The Optimal Mix: How Much Annuity Do You Need?

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Lately I’ve been writing about the case for annuities and my gradual acceptance of their likely role in my own retirement. (See Why an Annuity Could Be in Your Future and A Floor with an Upside: The Best Strategy for Lifetime Income?) Unless you commit to an extremely frugal lifestyle, or build assets into the multiple millions, there is a good probability that you’ll need to employ an annuity too, in some form, to meet your retirement income goals.

An annuity is a contract with an insurance company to pay a stream of income over a set period, possibly for life, in exchange for a lump sum. There are a dizzying number of annuity types and options, and I’m not going to get into those details here. (For a solid primer on annuities see What Is an Annuity and How Does It Work?)

When considering a fixed income annuity, there are at least two critical questions for a potential retiree: How much annuity do I need? And: When should I buy my annuity (or annuities)? To secure lifetime income, you must get both of those questions right.

I’m going to tackle the question of how much annuity you need here, and handle the timing question in a later article.

But, before we get started, let me redouble my usual disclaimer by saying we’re heading into terrain that could well require professional advice tailored to your personal situation. There are many variables when discussing retirement income and it’s impossible for me to know and address them all here. However, I do hope to shed light on a few key concepts that will put you on track to designing a good solution, if you’re a technically-minded do-it-yourselfer, or dealing with a financial professional who can do it for you.

Three Key Ratios

First some background: there are three rates or ratios that are the key to the entire puzzle. These aren’t complicated in themselves, but it is essential to grasp them each individually before we analyze just how much of an annuity you’ll need. Once you understand these rates, we’ll work through a simple example to see how large an annuity is needed.

The Sustainable Withdrawal Rate (SWR): I’m calling this a "sustainable" withdrawal rate rather than the more conventional "safe" withdrawal rate, which has become so identified with the 4% rule. That rule is under attack because of high current stock market valuations, the anomaly in U.S. vs. international market performance, and the extended length of modern retirements — which could well span 40-50 years. (The 4% rule was originally formulated for a 30-year retirement.) So by "sustainable" rate we are talking about a very conservative annual withdrawal rate, from an investment portfolio of between 40-60% stocks, that most modern experts believe would not risk depleting that portfolio over an indefinite time span. Nobody knows that number for certain, but in today’s world, 4% probably doesn’t cut it. Avant-garde researchers such as Wade Pfau and Jim Otar have argued that a modern sustainable rate could well be more like 3% or even less. Rather than try to prove the un-provable, I’m going to take 3% as a tentative value for our working example and move forward. You can adjust that number as you get more clarity on the economy and your own retirement.

Your Withdrawal Rate (WR): This is simply the shortfall in what you need to live annually (after pensions or Social Security have been applied against your regular expenses), divided by the total amount of your investment assets. The best way to determine the first part of this ratio is to track your expenses for at least a year. That way you’re using actual numbers and don’t overlook occasional costs such as auto maintenance, travel, or property tax. If you don’t own your house outright, you’ll need to include rent or mortgage interest in your expenses as well. By "investment assets" we mean the money that you can tap to pay for living expenses, via dividends or growth. So, for example, you shouldn’t count home equity. For our working example, let’s say you have a $1 million portfolio and need $40,000/year on top of pensions or Social Security to live. That makes your Withdrawal Rate 40,000/1,000,000 or 4%.

The Annuity Rate (AR): This is simply the annual payout on a fixed income annuity with the features you need, divided by the amount of money you must give the insurance company to purchase the contract. This rate will be a function of your age, the provider, the current state of the bond market and interest rates, and the type of annuity and the options you select. (For a refresher on annuities, see What Is an Annuity and How Does It Work?) If you are married, you’ll need a Joint Life annuity to cover you both with lifetime income, and this will reduce the rate. If you are concerned about inflation, and have no other protection, you’ll need an inflation-adjusted annuity, which will reduce the rate further. Annuity rates fluctuate constantly: right now they are relatively low, in concert with low interest rates. You can get quotes for your specific situation at or Vanguard. For our working example, let’s suppose that a $25,000/year payout with the features you need can be purchased for $500,000. In that case, the annuity rate (AR) for you is 25,000/500,000 or 5%. (Keep in mind this is a hypothetical number: your Annuity Rate will surely be different, depending on your circumstances and when and where you obtain a quote.)

A Common Scenario

So now we have some basic concepts in place — the three key rates for discussing an optimal annuity mix.

You’ll notice that when I explained the rates above, they appeared in order of increasing magnitude. In other words, the Sustainable Withdrawal Rate (SWR) was lowest at 3%, followed by your own Withdrawal Rate (WR) at 4%, followed by the Annuity Rate (AR) at 5%. (And remember that all these numbers, with the possible exception of the first, are purely hypothetical: you must replace them with your own values.)


“SWR less than WR less than AR” is a common scenario, and the one for which this article is most valuable, but it’s by no means the only possibility.

The big wildcard is your Withdrawal Rate, because that is a function of your desired lifestyle (expenses) divided by your savings (investment assets). And we know that for many boomers with insufficient retirement savings, equal to only a few years of living expenses, that ratio is off the charts — 30%, or worse.

Then there are those who have saved more than necessary, or are prepared to live a lifestyle of extreme frugality. For them, the Withdrawal Rate might be only a percent or two.

We’ll discuss those boundary cases shortly. But, for now, know that many who have saved diligently over a long career, and led a modest lifestyle, will have Withdrawal Rates between the Sustainable Withdrawal Rate and their prevailing Annuity Rate, and that’s the audience that will be most interested in what I have to say next….

The Answer in Words

Before we answer the annuity mix question precisely, let’s look at a simple, non-financial example:

What if you mistakenly began filling your car’s gas tank with 86 octane fuel, when the engine really needed 88 octane? You could potentially fix that problem by adding a higher octane, say 90 or 92, to bring the average octane up. It’s the same idea with buying an annuity. If you start with an unsafe Withdrawal Rate, you can move some of your investment funds into a relatively "high octane" annuity, to bring your overall withdrawal in line with a Sustainable Withdrawal Rate.

Back to the question: How much annuity should you buy?

Here’s the answer, in words: you need to buy enough annuity so that it pushes your remaining Withdrawal Rate (WR) down to the Sustainable Withdrawal Rate (SWR). Why do you need to do that? Because, if your WR remains greater than the SWR, you run a serious risk of depleting your portfolio over a long retirement starting from the current market conditions.

And how does an annuity fix that problem? Simple: because the Annuity Rate is higher than both your Withdrawal Rate and your Sustainable Withdrawal Rate in this example, whatever funds you put into an annuity will give you more income "bang for the buck" than your other funds, thus pushing your remaining WR down towards the SWR.

Annuities can pay more than prevailing interest rates because some of the money is return of principal, plus the insurance company keeps the annuity premiums of those who die early to make the payouts of those who live longer. The cost for that magic is the price of your annuity, because that sum is removed from your investment portfolio, and your estate, and winds up in the insurance company’s coffers.

The Answer in Numbers

And now for the formula that can apportion your investment funds, telling you just how much annuity to buy.

It’s pretty simple actually, and looks like this:

Annuity Percent = (WR – SWR) / (AR – SWR)

Calculating that for our working example we get:

(4% – 3%) / (5% – 3%) = 1/2 or 50%

So, if you were to have a $1 million portfolio and need $40,000 annual income to cover retirement living expenses, and you believe the highest Sustainable Withdrawal Rate is 3%, while the quote for your Annuity Rate is 5%, then you’d need to move 50% of your portfolio into an annuity to meet your retirement income objectives.

Let’s back-check this to make sure it works: If you had that $1 million portfolio and used 50% of it to buy an annuity paying out at a 5% rate, then you would be left with $500,000 in your portfolio and an annuity paying $25,000 annually. You could then take the conservative Sustainable Withdrawal Rate of 3% from that $500,000 remaining portfolio indefinitely, for another $15,000 annually in income. Add those two income streams (the $25,000 from the annuity plus the $15,000 from your portfolio) and you get the $40,000 in annual income that you required at the start.

It works. The formula produces the retirement income you need by combining a guaranteed lifetime income from an annuity with a very conservative Sustainable Withdrawal Rate from your remaining investment portfolio.

Boundary Conditions: The Other Scenarios

Before we end, let’s look at the boundary conditions. What happens if your own Withdrawal Rate is not within that common range in between the Sustainable Withdrawal Rate and the Annuity Rate? What if it’s less than the Sustainable Withdrawal Rate, or more than the Annuity Rate?

WR < SWR or AR < WR

Let’s start with the happy case: If your Withdrawal Rate is less than the Sustainable Withdrawal Rate, then you can dispense with these calculations and with annuities altogether, if you choose. Because your expenses are so low, or your portfolio is so large, you can rest easy knowing you can withdraw annual living expenses from your portfolio and your assets are likely to survive an indefinite time span, without needing the performance boost of an annuity.

As for the much more common, unhappy case: What if your Withdrawal Rate is greater than the Annuity Rate? Then the equation above will produce a percentage above 100%. Not good. That means to support your lifestyle, you need more money than you have. While buying an annuity could improve your situation, it can’t alone fix it. You are at risk of running out of money in retirement, unless you either cut back on your lifestyle and expenses, or work longer to generate more income.

Stay Tuned

So that’s it. I’ve explained one sound approach to answering the question: How much annuity do you need?

The solution, again, is that you need enough to push your Withdrawal Rate down below whatever truly Sustainable Withdrawal Rate is dictated by current economic conditions. This allows the remainder of your portfolio, which wasn’t used to purchase the annuity, to last indefinitely.

The simple equation above, a function of your Withdrawal Rate, the Sustainable Withdrawal Rate, and the Annuity Rate, tells you the actual percentage of your portfolio that must be moved into an annuity.

Stay tuned for more articles on retirement income. There is a lot left to say about choosing and timing annuities to meet the need for secure lifetime income….


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Credits: Jim Otar and his book Unveiling The Retirement Myth inspired much of my thinking on this issue. The key insights and some of the terminology here are thanks to Jim, though the presentation is mine. If you’re technically-minded, see his book for a more detailed discussion, along with extensive supporting data and examples. Otherwise see a professional adviser, like Jim, for help with your personal situation.