How Annuities Fit Into Your Overall Retirement Plan

An annuity shouldn’t be your entire retirement plan. Instead, it should be seen as one component that works in harmony with your other assets, like Social Security, pensions, and investment accounts. The most effective way to use an annuity is strategically, to solve a specific problem in your financial picture.

One of the most popular strategies is creating an “income floor.” The idea is to first map out your essential, non-negotiable monthly expenses. These are the bills you must pay every month no matter what: your mortgage or rent, property taxes, utilities, food, insurance premiums, and basic transportation. Then, you add up your sources of guaranteed income, primarily Social Security and any pensions you might have. If your guaranteed income covers all your essential expenses, you’re in a great position. But for many, there’s a gap.

This is where an annuity can shine. You can use a portion of your retirement savings to purchase an annuity that generates enough income to fill that gap, thereby building a “floor” of guaranteed income that covers all your must-pay bills. This ensures your basic needs are met for life. Your remaining savings in 401(k)s, IRAs, and brokerage accounts can then be used for discretionary spending, like travel, hobbies, and gifts for grandchildren, with more flexibility and a greater tolerance for market risk.

Mini-Math Example: Creating an Income Floor

Let’s walk through a simple example. Imagine Sarah is 67 and planning her retirement budget. She calculates her essential monthly expenses:

Her mortgage payment is $900.

Her property taxes and insurance average $400 per month.

Her utilities (electric, water, internet) are $300 per month.

Her Medicare premiums and out-of-pocket health costs are $450 per month.

Her groceries and basic supplies come to $650 per month.

Sarah’s total essential expenses are $900 + $400 + $300 + $450 + $650 = $2,700 per month.

Now, let’s look at her guaranteed income. After careful consideration, she started her Social Security benefit, which is $1,900 per month. She has no pension. This means she has an income gap: $2,700 (needs) – $1,900 (has) = $800 per month.

Sarah is worried about this $800 gap. She doesn’t want to rely on pulling it from her stock market investments, because she fears a market downturn could force her to sell at a loss. So, she decides to take a portion of her 401(k) savings, say $150,000, and purchase an immediate fixed annuity. Based on her age and current interest rates, the insurance company offers her a guaranteed lifetime payment of $820 per month. By doing this, she has completely covered her income gap. Her total guaranteed income is now $1,900 (Social Security) + $820 (Annuity) = $2,720 per month, which safely covers her $2,700 of essential bills. She can now manage the rest of her savings with much greater peace of mind.

Annuities can also help manage a critical retirement risk known as sequence of returns risk. This is a fancy term for a simple but dangerous problem: if the stock market performs poorly in the first few years of your retirement, your portfolio can be permanently damaged. Withdrawing money from a declining portfolio has a much bigger impact than withdrawing from a growing one. Because an annuity’s payments are guaranteed by the insurance company, they are independent of market returns. This provides a stable source of cash flow, allowing you to avoid selling your other investments when their prices are low, giving them time to recover.