Stocks are in a tailspin. Bonds and bank savings pay next to nothing. The job market for older folks is hardly welcoming. Wouldn't it be wonderful if those of us in or near retirement could fall back on the standby of yesteryear -- a good, old-fashioned pension?
Unfortunately, many cannot. Pensions today are rare, and even if you could find a job that offers one, it would take decades to build up a decent benefit.
There is an alternative, though. You can "buy a pension," by investing in an immediate annuity, which can provide a guaranteed income for life, starting right away. Many financial advisors have recommended this for clients jittery about counting on stocks and bonds.
"One of the biggest advantages to an immediate annuity is that it can provide the opportunity to receive guaranteed income for life, regardless of what occurs in the market, or even in the economy overall," says Brad Cummins, founder of Local Life Agents, an online insurer.
"Other financial alternatives may provide more or less income (than an annuity), based on what occurs in the market or what occurs with interest rates. (But) an annuity is the only financial vehicle that can guarantee that its owner will not outlive its income-generating capacity."
How an annuity works. Today, a 67-year old woman with $100,000 could buy an immediate annuity that would immediately start paying $6,660 a year and continue for as long as she lives, according to ImmediateAnnuities.com. Compare that 6.66 percent yield to the 1.67 percent you could earn with a 10-year U.S. Treasury note.
There are drawbacks, however. Most important, once you buy the annuity, your principal is gone -- it's not there for your heirs, or for you to tap for an emergency or to shift to a more attractive investment. If you die too soon, your annuity income may fall far short of what you'd spent. And part of that high "yield" is actually a gradual return of your principal, so the payout isn't really as generous as it seems.
Because buyers who die early will collect little, insurance companies that sell annuities can afford those large-looking payouts. But with a $100,000 annuity paying out $6,600 a year, the first 15 years of income is really nothing more than a return of principal. After than, the income is a true investment return.
Aaron Gilman, president of IFP Wealth Management in Tampa, Florida, says it typically takes about 14 years for annuity income to equal the policy's cost. Since an alternative investment would pay some interest and preserve principal, it takes about 30 years for an annuity to pay out enough to become an attractive investment, he says. A man who buys an annuity at 65 and dies at 84.4, the current life expectancy, would typically earn a lifetime rate of return of only 3 percent, Gilman says.
A buyer who lives long enough can indeed receive more in income than the annuity had cost, but 20 years from now that monthly payment will buy less than it does today.
"After accounting for inflation, the results become even less attractive, Gilman says. "At 3 percent (inflation), you only retain 55 percent of your original purchasing power by year 20," he says.
Insurers offer riders to increase payments to offset inflation, to provide income for a guaranteed period even if the policyholder dies, or to continue the income for a spouse. But all these reduce the payout.
The interest rate question. Another dilemma is whether to buy now or wait for interest rates to rise. Since annuity payouts are guided by the insurer's best guess about how much it can earn by investing buyers' payments, payouts are bigger when interest rates are higher.
If you knew rates would be substantially higher in a year, it would pay to wait. But it's impossible to know whether rates will rise and by how much, and waiting means forgoing income you could receive in the meantime. So if an immediate annuity looks good and you need income now, it might be best to go ahead.
To further complicate matters, buying at an older age can increase the income stream, since you won't receive as many payments as if you'd bought earlier. The woman mentioned above could receive $7,608 a year, instead of $6,660, by purchasing at 72 instead of 67. Of course, she'd miss out on $33,300 due to the five-year delay. (This assumes no change in interest rates.)
Who would benefit from an immediate annuity? Most experts say it's a person who needs dependable income for the gap between living costs and other income, such as Social Security; someone who's nervous about depending on volatile assets like stocks; and someone with a good chance of living a long time.
Even one who fits all these criteria would be wise to spend only a portion of retirement assets on an annuity, most experts say. Other holdings may offer better returns and will most certainly be more liquid, providing money for unexpected expenses.
"Once the annuity's stream of income is turned on, the decision cannot be reversed," Cummins says.
Given that, buyers should shop carefully, focusing on insurers with high ratings as well as comparing payouts and other terms. Consider consulting an insurance broker who represents a variety of providers and can advise on the pros and cons of options like inflation riders.
What are the best alternatives?
Gilman thinks a better option is a "laddered" portfolio of top-rated municipal and corporate bonds of various maturities. This would provide dependable income, and if interest rates rise the maturing bonds could be reinvested for higher yields, increasing the income stream and helping to offset inflation.
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