Finding Income in Retirement: Immediate Annuities

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An immediate annuity offers a guarantee for those fearful of the stock market

In the decade since she retired as an administrative secretary for a local school district, Hope DeSales Caines managed to make ends meet through a combination of a modest pension and Social Security. But recently, the Maple Shade, N.J., resident discovered that as the cost of living has risen, her income has not. Caines, 74, concluded that she needed to supplement those checks with the personal savings she cobbled together during her working years.

Caines was fearful of making the same mistake that friends had: losing money in the stock market. For retirees, the margin for error can be quite slim. Academic research shows investors can afford to withdraw only 4 to 5 percent of their savings annually if they want to be certain the money will last 30 years or more. And that's if you invest those assets soundly. "I always felt I worked hard for the money, and I didn't want to lose it," Caines says.

So instead of simply tapping her retirement accounts, last year she used a portion to buy a fixed immediate lifetime annuity through New York Life that promises to pay her income for life.

Immediate annuities have gotten a good deal of attention lately. As part of his plan to revamp Social Security, President Bush has broached the idea of retirees' purchasing annuities with money earned in the private investment accounts he favors.

Bum rap. Today, very few people choose to turn their 401(k)'s, IRA s, and private brokerage accounts into annuities at retirement. Part of the problem is that some associate the term annuity with variable deferred annuities, a combination life insurance and investment product that's often pushed by agents who work on commission and reviled by many cost-conscious financial planners.

But fixed immediate annuities are a different matter. While a variable annuity is a tax-deferred account used to accumulate assets for retirement, a fixed annuity is a tool designed to produce stable income during retirement. "People have historically benefited from a couple of different types of immediate annuities," says Harold Evensky, chairman of the financial planning firm Evensky & Katz.

These include traditional pension plans once offered by many companies. The other is Social Security itself. "The former is disappearing, and the latter is shrinking," Evensky says, adding that privately purchased "immediate annuities are going to play a hugely important role in workers' retirement plans."

In its simplest form, a fixed annuity is an insurance contract that promises you a set amount of annual income for life--no matter how long that might be. Think of it as your own pension plan. In exchange for a lump sum of $100,000, say, an insurance company promises to pay you $7,000 to $8,000 a year for the rest of your life. That's great if you buy one at 65 and live to 90 or older, since you will receive far more in payments than you put in. But should you die earlier than expected, the remainder of your initial payment belongs to the insurance company.

You can protect yourself somewhat by buying an annuity contract that guarantees payments for a set number of years. If you bought a 10-year annuity at age 65 but died at 70, your estate would collect the remaining five years of annual payments. Another criticism of fixed annuities is that over time the purchasing power of the income they produce diminishes. But today, some annuities also include inflation protection, increasing their annual payments by 2 or 3 percent a year or by adjusting their payments based on the consumer price index.

Annuities may even be a better investment than stocks at times, depending on market conditions. Baylor University investments Prof. William Reichenstein studied various portfolios between 1972 and 2000. He found that a 65-year-old retiree with a $1 million portfolio invested in a mix of 40 percent stocks and 60 percent bonds withdrawing $45,000 a year from his account would have run out of money in 1995, at age 88, in part because of poor performance in the early years. Had he taken half of his portfolio and bought a fixed annuity instead, he would still have had $136,000 left at age 95.

"The neat thing about fixed immediate annuities is that they function like bonds in your portfolio," says Reichenstein. But the added advantage of the lifetime versions is that they promise to pay you the same amount until you die, not simply over five or 10 years. Moreover, while bonds can lose value, there is no such risk with these types of annuities. Because annuities are like bonds, investors don't have to have as much of their portfolios in fixed-income investments.

Margin of safety. Because insurance companies pool the money and life expectancies of thousands of annuity buyers, they can typically offer more income than an investor could safely generate with the same amount of investment. A 65-year-old man might only feel comfortable taking out $5,000 at most from a $100,000 retirement account. But that same man could go to an insurer and get a fixed annuity paying around $7,500 a year for the rest of his life.

"If you think you need a million dollars to retire but saved only $750,000, you can annuitize a portion of your account to spend as much as someone with $1 million," says Rande Spiegelman, vice president of financial planning for the Schwab Center for Investment Research.

But this does not mean an immediate annuity is for everyone. Some might already have enough guaranteed income from a traditional pension plan at work, for example. And you should not use all or even most of your assets to purchase an annuity. You never know when an emergency might arise or when your cash-flow needs will change. Most annuities lock in your money once you start receiving income.

The first thing to do is tally up your basic expenses, such as rent or mortgage, food, utilities, and healthcare bills. Then, add up the income you expect from Social Security and traditional pensions. If Social Security and your pension don't cover all your basic needs, consider filling in the gap with an immediate annuity, says Ted Mathas, executive vice president of New York Life.

You should not hurry into a decision. For one thing, annuity payouts are tied to long-term interest rates, and those may be headed upward. Payments are also tied to age, just like Social Security. So by waiting even five years to sign up, you can increase your monthly income significantly, says Tim Vander Pas, head of annuity product management at Allstate Life Insurance Co.

At Allstate, a 65-year-old male could currently purchase a $100,000 single-premium immediate annuity and receive $622 a month for life. But a 70-year-old who buys the same annuity gets $712 a month.

Of course, some retirees can't afford to wait to start receiving income. If that's the case, consider buying a small annuity now that's enough to cover basic expenses, such as rent and food. Then, if your income needs increase, you can always purchase another annuity contract to supplement the current one.

"One of the things we've advocated is laddering your income annuities, like you would CD s or bonds," says Drew Denning, a vice president for income management at Principal Financial. "So maybe you break your purchase into three chunks, with a portion bought one year, another bought the next year, and a third bought a few years after that."

Consider using different providers for each annuity. You are entering into a long-term contract, and since there is no way to tell with absolute certainty if your insurer will be around 35 or 40 years from now, it pays not to put all your annuity eggs in one basket. Stick with insurers who have strong financial profiles, such as those rated AA or higher, says Reichenstein.

And think twice about all the add-ons, says Rob Nestor, a principal with the Vanguard Group. While inflation kickers might sound attractive--after all, everyone wants to keep up with the cost of living--bells and whistles can be expensive. At Vanguard, a 70-year-old who buys a $100,000 immediate annuity can expect around $9,000 a year for the rest of his life. But an inflation-indexed contract at Vanguard would begin with a payment of about $6,750, which then would adjust up annually as prices rise. "That's a pretty big haircut," Nestor says.

Remember, annuities are supposed to be only one part of a diversified overall retirement plan. You can always use the other half or three quarters of your money to invest in a mix of bonds and stocks, which is a natural hedge against inflation.

Annuities 101

A single-premium fixed immediate lifetime annuity is an insurance contract that promises to convert an unpredictable asset--an investment portfolio of stocks and bonds, say--into a predictable stream of income at retirement.

The term single premium refers to the fact that you pay with a lump sum.

Fixed means the income will not fluctuate over time (though now you can buy inflation-adjusted annuities).

Immediate means the insurer will cut you the first check soon after you purchase the annuity.

And lifetime means you will keep receiving that income even if you live to 120.

The level of monthly income you receive will depend on three things: prevailing market interest rates, your age, and your gender, as women tend to live longer than men.

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