Vol 9 No 10		December 2007

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Variable Annuity for Retirement Income

"While the Monte Carlo results are a dramatic demonstration of the risk compared to the joint IA income, there is a segment of the investing public that have an unshakeable confidence in the magic of stock market returns. They understand that large losses occur but that on average it will return much better results than something like a joint IA."

An interesting case involving Sam, a 67 year old retired surgeon with a wife 53 may uncover some issues worth considering. Sam has a deferred variable annuity with a balance of approximately $3,000,000, an IRA with $2,000,000, other marketable securities of $900,000 and real estate in several properties of $2,000,000 (the liquidity of which is murky at the moment). A financial advisor recommended that he begin withdrawing funds from his VA for his primary retirement income. I raised the option of converting the VA to a joint life income annuity. An interesting sideline to this is a nearly defunct VUL with a cost basis of $578,000 that can be transferred into the IA to increase its cost basis and decrease taxes with a present value advantage of about $120,000.

The use of the VA for retirement income will either end up as a train wreck or the equivalent of having one's cake and eating it to. There are two problems with the VA. First it is very tax adverse because all withdrawals of earnings are ordinary income. Much worse are the probabilities that it will fail, or probably more realistically, take a steep plunge and Sam will head to the high ground giving up the potential for large market gains with much less income.

A joint IA will provide $140,000 after tax income for 32 years and then $121,000. Pre-tax withdrawals from the VA need to be about $233,000 to match the joint IA. I did Monte Carlo testing on the VA withdrawals to match the joint IA income using 10% arithmetic mean and 20% standard deviation. The following table shows the results for complete failure, the balance falling to one-half and probabilities either Sam or his wife will be alive.

VA Results Paying Out IA Income

As this is written Sam hasn't been able to make up his mind. While the Monte Carlo results are a dramatic demonstration of the risk compared to the joint IA income, there is a segment of the investing public that have an unshakeable confidence in the magic of stock market returns. They understand that large losses occur but that on average it will return much better results than something like a joint IA. What isn't being properly interpreted by Sam, I think, is the much greater risk involved with annual withdrawals made from a VA (or any stock fund).