As rumors spread that President Barack Obama might utter the word "annuity" during his State of the Union address earlier this year, the insurance industry went wild. Salespeople touted the president's impending seal of approval as a reason to buy their wares -- even if the high-fee, complex versions they were promoting only vaguely resembled the products that the president supports.
Although Obama never actually uttered the A-word in his speech, his Middle Class Task Force later recommended annuities as a good way to reduce "the risks that retirees will outlive their savings or that the retirees' living standards will be eroded by investment losses or inflation."
The need for lifetime income is huge -- and growing -- as life expectancies continue to increase and traditional sources of guaranteed income disappear. For a 65-year-old couple, there's a 25% chance that one spouse will live until age 97, yet fewer people are retiring with pensions, and Social Security covers only a small portion of most people's expenses. Many retirees who had planned to fill the income gap with their savings are wondering where to turn after suffering through two severe market downturns over the past decade. An annuity may be the answer, but not all annuities are alike, and some may not be appropriate for you.
Plain and simple
An immediate annuity is based on a simple concept: You give an insurance company a lump sum, and it promises to send you a monthly check for the rest of your life, no matter how long you live. For example, a 65-year-old man who invests $100,000 in an immediate annuity today could collect $8,112 a year for the rest of his life. That's about twice as much as he could safely withdraw from his savings each year if he followed the widely accepted recommendation to limit initial annual withdrawals to 4% of the total portfolio to avoid outliving savings.
Part of the reason for the bigger annuity payout is that each distribution consists of interest as well as a return of principal. But the real secret behind the beefed-up annuity checks is that you pool your risk with other policyholders. People who die early end up subsidizing the payments of people who live longer.
You get the biggest bang for your buck if you buy a "straight life" annuity, which pays out only for your lifetime, with no survivor benefits. But most married couples prefer to buy annuities that pay out as long as either spouse lives, even though it means smaller benefits. For example, a 65-year-old couple who invested $100,000 in an immediate annuity and chose dual coverage would receive an annual payout of $6,634.
Buying an immediate annuity helped Elaine Leaf stretch her retirement income. Ten years ago, Leaf, now 63, retired from a career in radio and moved from New Jersey to Edgewater, Fla.
"I thought I could live on the funds from the sale of my house," she says. But she soon discovered she was wrong. Medical insurance premiums alone were $1,000 a month, and her investments took a major hit during the 2000-02 bear market.
Leaf took a job as a cashier at a discount clothing store to earn extra money and qualify for health insurance, but she was miserable. Her financial adviser recommended that she buy an immediate annuity from New York Life. She invested about $375,000 and now receives $2,500 a month, twice as much as she was able to withdraw safely from her savings. (Because interest rates were higher four years ago, Leaf locked in a bigger payout than a 59-year-old could buy today.)
"I feel protected for life," Leaf says. "Now I can count on a check that comes every month like clockwork."
How to shop
When deciding how much to invest in an immediate annuity, follow Leaf's lead: Add up your monthly expenses, subtract any guaranteed sources of income (such as Social Security and pension benefits) and buy an annuity to fill the gap. But watch out: Payouts can vary enormously by company, so it's a good idea to compare prices from many insurers."There's easily a 10% to 15% spread from the top to the bottom of the list," says Hersh Stern, the publisher of AnnuityShopper.com. Another Stern website includes a database of more than a dozen annuity companies, making it easy to compare benefits.
One risk of immediate annuities, however, is that your fixed monthly check will lose purchasing power over time, so it's important not to tie up all your cash. Interest rates and your age at the time of purchase also affect the size of your monthly check. Because current interest rates are so low, you may want to ladder annuities, meaning you invest some money in an immediate annuity now and buy another one later when interest rates may be higher. Plus, you'll get a bigger payout because you'll be older and have a shorter life expectancy.
Another option is to buy an immediate annuity with inflation protection. Chris O'Flinn of ELM Income Group in Washington, D.C., recommends buying an annuity with annual payout increases linked to the Consumer Price Index. Although the initial payouts are about 25% to 30% less than you would get by investing the same amount in a fixed annuity, you'll preserve your buying power. "When inflation comes, it tends to gallop in and stay around for quite a while," O'Flinn says.
