Stung by the stock market’s collapse, many retirees and pre-retirees are turning to annuities to provide guaranteed income for life. Sales of immediate annuities -- contracts issued by insurance companies that convert a lump-sum payment into a guaranteed stream of cash flow -- have soared in recent months. Part of the attraction is that some annuities offer better returns than bank certificates of deposit (CDs) or short-term government bonds, but there are many dangers amid the opportunities. New products have been designed to counteract the disadvantages, but it’s a confusing array. When it might be wise to consider an annuity -- and how to avoid the traps...
You’re newly retired. You want a guaranteed payout to start quickly and provide stability throughout your retirement.
Solution: An immediate, fixed lifetime annuity.
How it works: You sign a contract and write a lump-sum check to an insurance company. The insurer invests the money and guarantees to pay you a predetermined fixed dollar amount (on a recurring basis) for the rest of your life.
Example: A 65-year-old who buys an immediate, fixed lifetime annuity today may receive $6,000 to $8,000 per year for each $100,000 invested in the annuity. The payments are partially growth and partially a return of principal. Drawbacks...
Lack of inflation protection. Without inflation adjustments, the annuity payments may be unable to cover your needs in later years.
Lack of significant capital appreciation. The amount you invest in an annuity might provide you with much higher returns if you invested in riskier assets, such as stocks, though, of course, there’s no guarantee that would happen.
Wait a year or so into retirement before buying an immediate annuity. At that point, you will have a realistic idea of how much money you need each month.
Example: A 65-year-old man has a $1 million nest egg and needs $40,000 a year in living expenses in addition to Social Security. He’ll likely have to invest at least $500,000 in an annuity to receive that much, leaving him $500,000 to invest in a mix of cash and bonds for short-term needs and stocks for longer-term appreciation.
Do not use all or nearly all of your retirement money to buy an immediate annuity. Instead, buy one that, when combined with the Social Security benefits you receive, covers no more than your basic living expenses each month. That way, you’ll be able to invest your remaining money more aggressively, if you choose to, without having to tap into it during downturns in the market.
Add an inflation rider to your contract if you can. If your payouts remain the same over time, inflation can eat away at the purchasing power of that money. An inflation rider increases your payments annually to keep pace with inflation. Such a rider is expensive. You can expect your initial payouts to be at least 20% lower than initial payouts without an inflation rider.
Note: Many companies do not provide this option. Companies that do offer this option include The Vanguard Group and New York Life.
Consider a "joint and survivor" annuity if you’re married. This type of fixed lifetime annuity stipulates that in the event of your death, your spouse will continue to receive your regular payouts.
Cost: The initial payouts you receive will be at least 10% lower than with a single-life annuity.
Buy a "life with term certain" annuity. These annuities provide payments for life but also guarantee a minimum number of payments -- so if the "for life" time period turns out to be short, heirs still receive some, and possibly most, of the money back.
Create a "ladder" of immediate annuities by purchasing several contracts over a number of years. The average payouts for annuities tend to rise and fall with interest rates at the time of purchase. Since interest rates are so low now, payouts on annuities will be relatively skimpy. By staggering your purchases annually over the next several years, you make sure that not all of your money gets locked in to a lifetime of lower annual payments.
You’re nearing or in retirement. You don’t need a guaranteed payout now, but you want to be sure that you have payouts when you get older, especially if you might face higher health-care costs or live to a very old age.
Solution: A fixed "longevity" annuity.
How it works: It’s like having an immediate annuity that doesn’t start for 20 years. You pay for it now and the money grows on a tax-deferred basis until you reach old age, typically 80 or 85. At that time, the insurance company begins to pay you guaranteed, regular income that will continue for the rest of your life.
Example: A 65-year-old woman can typically get a $60,000 a year payout starting at age 85 for an investment of about $71,000.
Drawbacks: Your heirs get nothing if you die before you begin to receive payments, and there are no inflation riders available.
Wise move: Buy the longevity annuity when you retire. My clients typically buy them in their 60s.
Reason: Coverage is relatively cheap at that age.
You are still working. You want to keep your nest egg growing aggressively right now, but you also want to make sure that you have some guaranteed income when you do retire.
Solution: A variable annuity. Variable annuities offer the possibility of better returns than fixed annuities and some level of guaranteed payout.
How it works: You invest a lump sum in stock or bond mutual-fund-like portfolios called "subaccounts." Investing in a variable annuity has a couple of key advantages over simply investing on your own in mutual funds -- your money grows tax-deferred... and you may get some form of guaranteed payout at an agreed-upon age in the future, depending on whether and what type of guaranteed income rider(s) are purchased.
Unlike with a fixed annuity, a variable annuity allows you to access your principal should your plans change. You also typically get a death benefit so that your heirs receive a payout at least equal to the amount you initially invested, minus your withdrawals, even if your investments perform poorly.
The most logical candidates for variable annuities are investors in their 50s who have already maxed out their retirement plan contributions and don’t need to convert investments into an income stream for at least five or 10 years.
Drawbacks: Fees are higher and more complex than if you simply invest on your own in mutual funds. Add to that the costs of investing in the subaccounts and the cost of guarantees and riders, and it could easily mean that about 2% to 4% of your total invested amount annually goes to fees. You also face stiff penalties with variable annuities. For instance, if you access your principal within the first seven years, you might pay a surrender fee of 1% to 7% of the money you withdraw after a limited number of penalty free withdrawals.
Tax liability: You owe ordinary income tax on any investment gains you get as payouts, but no tax on your original principal.
Wise move: Consider buying a guarantee that you can sustain a certain amount of income over time if your principal declines or is exhausted. These guarantees are known as "living benefits riders."
Riders typically come in three varieties: Guaranteed minimum income benefits and guaranteed minimum withdrawal benefits, each of which provides some type of minimum guaranteed amount of future retirement cash flow... and guaranteed minimum accumulation benefits, which may make a policyholder’s nest egg whole after 10 years if there are no withdrawals, even if it is worth less than what he/she started with.
Cost: An additional 0.4% to 0.8% in annual fees.
Note: Whichever type of annuity you buy, be sure to set aside money for "liquidity needs," that is, money to cover emergencies that come up.
How to Shop for an Annuity
Find the best payout. Fixed and variable annuities are sold through insurance agents, banks and major investment firms. But the contracts themselves are actually issued by life insurance carriers, such as Metropolitan Life and Prudential. Since each insurer uses proprietary formulas to determine the payouts you get, and since annuity prices aren’t negotiable, it pays to comparison shop. For example, an immediate annuity with a survivor benefit purchased today for a man age 70 could pay from $516 up to $769 per month based on a lump sum of $100,000.
Investigate the financial strength of the insurance company that guarantees your annuity. The current financial crisis and the collapse of some insurers has heightened fears about whether the insurance companies we hand our money to will be around in later years to make payments.
Best: Check the health of the annuity issuer with three major independent rating agencies -- A.M. Best (www.ambest.com), Moody’s (www.moodys.com) and Standard & Poor’s (www.standardandpoors.com). Each rating firm has its own grading scale and research methods. Limit your options to insurers that receive either an A+ from A.M. Best or AA or better from Moody’s and Standard & Poor’s.