Retirement planning is largely about managing unknowns, and one of the biggest unknowns that a planner must contend with is life expectancy. If a retirement plan assumes too low of a life expectancy, it can easily fail as retirees outlive their assets. Still, overly cautious assumptions about life expectancy can short-change retirees and result in a retirement withdrawal rate that's much lower than it could be. That translates into a lower standard of living for the retirees and perhaps a bigger inheritance for their heirs. While giving more money away when you die might seem like an ok idea, most would agree that it shouldn't come at the expense of a comfortable retirement.
This is where single premium immediate or deferred annuities could help. In exchange for a lump sum payment, an immediate or deferred annuity provides a guaranteed stream of payments that continue until the annuitant dies. With an immediate annuity (SPIA), the stream of guaranteed payments begins immediately. In the case of a deferred annuity (SPDA), the payments begin at some pre-specified later date.
With these instruments, the annuitant can transfer the risk of "living too long" to an insurance company. If the annuitant dies early, the insurance company makes out, but if the annuitant lives an unusually long life, the annuitant makes out. Regardless of how things actually go, these contracts can be a good deal for retirees because they allow them to transfer some of the risk of a big unknown to a third party, the insurance company.
While immediate annuities can make sense in theory, the trick is in figuring out if a particular immediate annuity is a good idea in a particular retirement plan. There are so many factors to consider that the analysis can quickly become very complicated. The best way to analyze this type of problem is with a technique called Monte Carlo Simulation. Monte Carlo Simulation uses probability theory coupled with thousands of trial "runs" through a retirement sequence to explore the range of likely outcomes. This approach is widely used by financial planners in retirement planning.
Sounds pretty complicated, right? Well, it doesn't have to be. You can run the numbers yourself using an online Monte Carlo retirement calculator. These sophisticated planning tools are great for exploring complicated scenarios and boiling the results down into an easy to understand "probability of success." There's an online Monte Carlo retirement calculator at
