Immediate Annuities: 5 Rules to Get Monthly Checks for Life
By Kathy Kristof - feature MoneyWatch August 31, 2009, 3:00 AM
If the market crash taught us anything, it's that some sources of retirement income need to be rock solid. Given the now obvious shortcomings of the 401(k) and the fact that fewer and fewer of us have a company pension, it makes sense to set up a reliable income stream that will continue for as long as you live. Indeed, with life spans increasing, longevity risk — the danger that you'll run out of money before you die — has become a serious issue.
Anyone nearing retirement should consider buying an immediate annuity, which is about as close as you can come to creating your own pension. An annuity pays out a guaranteed monthly stream of income for the rest of your life.
The first thing you’ll have to get past is the name. Many investors hear the word annuity and start running faster than Usain Bolt. Annuities have gotten a bad rap, thanks to predatory salesmen selling inappropriate products with usurious fees. And while that reputation is probably deserved, it’s because of variable annuities, a financial product that combines a mutual fund and an insurance policy. Immediate annuities, on the other hand, are fairly plain-vanilla products, and financial experts say they can boost the performance of your retirement portfolio. A study by Ibbotson Associates, a Chicago-based investment-research firm, found that putting a portion of assets into a fixed annuity allowed investors to take more risk with their remaining assets and earn better returns on them.
With an immediate fixed annuity, you give an insurer, bank, or mutual fund company a chunk of money known as the premium, and then the company invests the cash in conservative bonds and securities and immediately starts paying you a set monthly stipend based on your life expectancy and interest rates at the time of purchase. The purchase is typically irrevocable. Generally, only a small portion of each payment is taxable. What if you get hit by a bus and die the day after purchasing the annuity? Bad luck for you and your heirs, unless you buy a plan that guarantees a return of your principal. Keep in mind, however, that the problem you are solving with an annuity is not that you might die young — that’s what life insurance is for — but that you might outlive your savings. The insurance company is betting that you won’t live longer than the actuarial tables predict — if you live to 105, the monthly checks keep on coming, and not only have you protected yourself from the poorhouse, you’ve also made out like a bandit. A 65-year-old woman investing $100,000 in an immediate annuity today would receive about $630 a month, according to ImmediateAnnuities.com; a 65-year-old man would get $684. (The guy gets more because of his shorter life expectancy.) These payouts don’t mean the annuitants are getting 6.3 percent or 6.84 percent returns, though. With an immediate annuity, your monthly payments are partly a return on your principal and partly a return of your principal. That’s why you pay tax on only a percentage of the payment.
Since you don’t know how long you’ll live, it’s impossible to say exactly what rate of return an immediate annuity will provide.
Some annuities, however, are better than others. Here are five rules to help you shop wisely for an immediate fixed annuity:
1. Limit the amount you’ll invest
Don’t put your entire retirement portfolio into an immediate annuity, because annuities are generally inflexible and illiquid, says Christine Fahlund, senior financial planner with T. Rowe Price in Baltimore. To determine the right amount, pencil out your fixed expenses in retirement, says Tom O’Connor, a financial planner with Abacus Wealth Partners in Pacific Palisades, Calif. Will fixed costs such as your mortgage, insurance, and property tax be covered by fixed streams of income like Social Security and company pensions? If not, O’Connor says, consider filling the gap with income from an immediate annuity.
2. Stay under
the safety limits
An immediate annuity isn’t guaranteed by the federal government like an insured bank CD. The payments you’ll receive are backed by the company issuing the annuity. So if the firm fails, your income could be jeopardized. State life-insurance guaranty funds do back annuities — but only up to a point. Although their coverage limits vary, the state funds typically cover up to $100,000 in the present value of annuity payments (some go up to $500,000).
To find a safe insurer, you can start your search by checking the companies’ financial-health ratings by outfits such as Moody’s, Standard & Poor’s, Fitch, A.M. Best, or TheStreet.com. But don’t stop there: While they are offering a snapshot of today’s corporate health, you need to feel secure about payments due 20 years from now. So go to your state guaranty fund’s Web site and learn its coverage ceilings. If your original premium is below the limit, you’ll be safe. But if you want a bigger annuity, diversify among insurers so none of your contracts exceeds the state’s limit, says David Adler, author of Snap Judgment and a contributor to Financial Planning magazine.
3. Decide how long you want payments to continue
Immediate annuities can be paid out over your lifetime; over the joint lifetimes of you and your spouse (known as “joint life”); for a set period; or for a guaranteed period, plus the rest of your life. Which option you choose will have a dramatic impact on the size of the monthly payout. As a rule, the shorter the time period, the bigger the monthly benefit.
Take a look at these payout ranges for a 65-year-old interested in a $100,000 immediate annuity. If he wanted payments for the rest of his life, he’d receive $684. If he bought the annuity for his life but wanted to make sure that either he or his heirs would get payments for at least 15 years, the monthly payment would drop to $607. And if he wanted a joint-life annuity to also last for the lifetime of his wife, now 65, the payment would fall to $561.
4. Get inflation protection
This option is worth getting, says Fahlund, because the steady drip of even low inflation can eat into your buying power over time. You can buy an annuity that will boost your monthly income each year based on a prescribed inflation rate (typically 3 percent or 4 percent), but a better option is to get one based on the actual change in the Consumer Price Index. Since the annuity issuer will build the cost of this option into your monthly payout calculations, betting on a predetermined rate only rearranges the monthly payouts. By linking the payouts to the CPI, you’ll protect yourself against an unexpected spike in inflation, no matter how dramatic.
5. Shop around for the highest payouts
Just as Nordstrom charges more for a dress than discounter H&M, different insurers charge different rates for immediate annuities. A 65-year-old woman from California, for example, would get $547 per month if she bought a single-life $100,000 annuity from Transamerica, but $589 with USAA, the insurer offering the highest quotes in a June 2009 Consumer Reports analysis. That $42-a-month difference adds up to roughly $10,000 over 20 years — too much to ignore. Once you’ve decided the type of immediate annuity you want (single life, joint life, etc.) and whether you want the inflation feature, call at least three companies or insurance agents for quotes to compare. Bear in mind that insurers with the highest financial-safety ratings often pay out less per month than those with lower ratings. TheStreet.com has a list of life insurers with its highest and lowest financial-safety ratings; Consumer Reports Money Adviser found TheStreet.com’s ratings the most accurate estimate of insurers’ health during the 2008 downturn.
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Kathy Kristof is an award-winning financial journalist and the author of Investing 101.