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For clients who want minimal equity market risk in generating retirement income, the dominant options are building a bond ladder or purchasing a lifetime annuity.
The bond ladder is one of the most straightforward income strategies to give a client cash flow in each year of retirement. Just buy a series of bonds that will mature for the desired amount of spending in each year of retirement. Ideally, the payments are secured to an advanced age in case the retiree lives that long.
Unfortunately, if the retiree dies earlier than projected, there will be a lot of money left over that could have been spent but wasn’t. But that’s simply the risk of an unknown retirement time horizon.
In the case of a lifetime annuity, on the other hand, the time horizon is known, at least in the aggregate if not to the individual client — because, with enough people, the mortality rate actually becomes highly predictable, even if it isn’t known exactly which people will pass away from one year to the next.
Nonetheless, by operating on the assumption that some people will die each year, an annuity can pay out a portion of the funds that will eventually be left behind by those decedents.
This is important because it allows the immediate annuity to provide larger guaranteed payments for the group than any individual could generate on his/her own.
These excess payments are known as mortality credits, and they represent a unique aspect of lifetime annuities that doesn’t exist with an individual bond ladder.
The advantage of mortality credits exists only by virtue of the fact that the other annuitants — rather than the annuity owner’s heirs — will benefit from any unused funds.
BOND LADDERS
Imagine for a moment that a 70-year-old retiree wishes to secure what he thinks will be a remaining 25-year retirement — protecting against the “risk” of living to age 95 — without taking any stock market risk. In that case, the retiree will simply buy a series of bonds that will provide the maximum possible level payments.
Assuming an average bond return of 3% (given current interest rates), the client could effectively amortize principal over a 25-year time horizon by spending $57.43 per year for each $1,000...