Deferred Income Annuities Can Replace Pensions -- for Some People

TheStreet.com

NEW YORK (BankingMyWay) -- As a way to help retirees avoid outliving their money, longevity insurance sounded like a great idea, but it never really took off. Now, though, the basic idea is back with a few improvements, and sales are up as growing numbers of baby boomers approach and enter retirement. The stars are aligning.

LIMRA, the insurance industry research and consulting group, says sales of "deferred income annuities" doubled last year to $2 billion, as the number of insurers offering these products also doubled, to 10. Those sales are still pretty small, but investors, after seeing early retirees' suffering in the financial crisis, may now see the merits of ensuring a dependable fixed income for their later years.

Many find that DIAs can stand in for the traditional pension, which is becoming a dinosaur. Fidelity compares a number of them on its site.

DIAs basically work the same as longevity insurance, or longevity annuities, as they were officially called. You pay a premium as you would for car insurance, and a number of years later the insurer starts paying you a monthly income that is considerably higher than you could earn with bonds, bank savings or other fixed-income assets. Best of all, the income keeps flowing for life.

An example offered by Morningstar, the investment-data firm, shows that a man who pays $100,000 for a DIA at age 65 could get as much as $56,000 a year starting at age 85. A 30-year Treasury bond that size would pay only $3,630.

How is this outsized payment possible?

First, because the deferred period -- the time before you start getting payments -- allows the insurance company to earn investment returns that deepen the pool of assets from which payments are later drawn.

Second, pooling funds from many investors allows risks to be shared. If you live longer than actuarial tables predict, your payments will be subsidized by funds from investors who didn't live as long as expected or haven't started getting payments yet. With enough people in the pool, the insurer has a pretty good idea how long the average will live.

According to Morningstar, most of today's investors opt to start payments well before age 85. Instead of using DIAs to insure against outliving their money, they use them for a guaranteed income in retirement. They invest in their 50s or early 60s and start payments in their 60s or 70s.

This provides a smaller payment that one would get with a longer delay, but still more than with standard fixed-income investments or "immediate income annuities," which start the income flow as soon as the premium is paid.

Morningstar says a man who pays $100,000 at 55 could collect $11,200 a year starting at 65. A woman would get less because of longer life expectancy.

Of course, the investor could keep that money in stocks and might produce a larger income if he got lucky, but with a DIA the payout is guaranteed so long as the insurer stays solvent.

There is a catch: If the investor dies before the payments begin, the money spent on the premium is lost, just as money spend on car insurance is lost if you never file a claim. This is one reason longevity insurance never took off.

To sweeten the deal, insurers have added various bells and whistles, such as a guarantee payments will continue for a spouse after the insured person dies, or will grow with inflation. Selecting any of these options reduces the payments, considerably in some cases.

Putting your life savings in to a DIA would probably be unwise, but a deferred income annuity can be a good option for a portion of your long-term retirement funds, ensuring a dependable income regardless of how the financial markets fare. If you know this income will come to you later in retirement, you can plan your spending better in the earlier years -- perhaps spending more because you don't need a cushion for an unexpectedly long life.

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