Using Immediate Annuities to Guarantee Retirement Income

They're still a marginal product. But in exchange for a lump sum, they offer regular payments for life.

By Walter Updegrave July 4, 2014

This article appears at the following website: wsj.com

With thousands of baby boomers hitting retirement age each day, you might think that investments that offered guaranteed income payments would be among the most popular. Yet immediate annuities — which, in return for a lump sum, do precisely that — are still something of a marginal product.

Economists have long considered such annuities one of the most effective vehicles for maximizing the income you can draw from retirement accounts while simultaneously guaranteeing income for life.

Their sales have surged lately—up 47% this year's first quarter over the same period last year, according to Limra, an industry-funded research group—and are projected to grow steadily over the next few years. But immediate annuities still account for less than 10% of annuity sales overall.

Why the disconnect? One reason is that other, high-fee versions of annuities are sold more aggressively. But it also is because many people may not understand how immediate annuities work.

The concept behind them is actually quite simple.

Immediate annuities are sold by insurers, which collect a one-time premium, invest the money and make a predetermined payout to the buyer each month. That payout consists of principal, investment gains and an extra amount known in insurance circles as a "mortality credit" — essentially a transfer of money from those < href="annuity-shopper/">annuity buyers who die sooner to those who live longer.

It is this additional payment that allows annuities to pay more from a given amount of savings than individuals could draw on their own without taking on more risk.

The monthly payout you receive when you buy an immediate annuity depends on your age, gender and prevailing interest rates. Today, a 65-year-old man investing $100,000 would receive roughly $565 a month; a woman the same age would get about $535 (because women live longer on average than men). A couple—a man and woman both 65—could opt to receive a monthly payout of about $475 a month that would continue as long as either is still alive.

So what isn't to like in such an arrangement?

Well, for one thing after you hand over your money to the insurer in return for lifetime payments, you would no longer have access to it, say, for unforeseen expenses. Nor would you be able to pass any of it on to your heirs.

And should you get hit by the proverbial bus soon after buying, the money that you would have been collecting instead helps the insurer deliver ongoing payments to other annuity customers.

But such factors shouldn't necessarily eliminate an immediate annuity as a retirement-income option. Consider putting only a portion of your 401(k), individual retirement account or other retirement savings into one—perhaps enough so that, along with Social Security and any pension, you can cover all or most essential retirement expenses. You can then leave the rest of your retirement savings in more-liquid investments, such as stocks, bonds or mutual funds and, if you wish, still set aside money for your heirs.

Despite their unique advantages, immediate annuities aren't for everyone. If Social Security and pensions will generate enough income to pay most of your expenses, then you probably don't need an annuity. The same is true if your nest egg is so large that you are unlikely to run through it.

And if you just can't get over the psychological hurdle of no longer having access to even a portion of your savings, then an immediate annuity probably isn't for you either.

There are "cash refund" immediate annuities that upon your death will pay your beneficiaries any of your original premium that you didn't receive in payments, but depending on your age and gender, the payment could be lower than that of a standard immediate annuity by 10% or more.

Similarly, many so-called variable annuities, which allow you to invest your money in mutual-fund like accounts, come with a lifetime-payout rider that allows you to retain access to your annuity's account value during your lifetime, and leave any remaining account value after you die to your heirs. But the products often come with onerous fees and can be exceedingly complicated to boot.

Here are some things to consider before purchasing an immediate annuity.

Browse before buying. Monthly payouts can easily vary 5% to 10% from one insurer to another. You can get quotes from several insurers by going to ImmediateAnnuities.com, an online annuity brokerage firm. A number of large investment firms, including Fidelity Investments, Charles Schwab SCHW +0.16% and Vanguard Group, sell immediate annuities.

Don't go all in at once. Buying in stages over several years will reduce the chances of you committing all your money when interest rates are very low, as they are today. This phase-in strategy also will give you more time to gauge your retirement expenses and better assess how much guaranteed income you really need.

Emphasize security. To assure that the annuity's monthly payments will arrive uninterrupted for the rest of your life, you will want to buy only from insurance companies that receive high financial-strength ratings from firms like Standard and Poor’s and A.M. Best. For an additional measure of safety, diversify—both by spreading your money among annuities from two or more highly rated insurers and by limiting the amount you invest with any single insurer to the coverage limits of the life-insurance guaranty association in your state, typically $100,000 per insurer.