Pensions may be going the way of rotary phones, but retirees looking for a substitute may want to investigate immediate annuities. These insurance products are expected to grow in popularity as the number of traditional pensions declines and baby boomers scramble for guaranteed sources of income, according to James Lange, author of "Retire Secure!"
Purchasing an immediate annuity is like buying a monthly pension check. You pay an annuity provider a lump sum in exchange for a guaranteed income stream. The monthly payments start immediately -- usually within 30 days of handing over your money.
Immediate annuities shouldn't be confused with deferred annuities. A deferred annuity is a retirement savings vehicle in which you sock away money on a tax-deferred basis just as you would with a traditional IRA. When you reach retirement, you can withdraw it as a lump sum or as a series of payments. The money is taxed at the time of withdrawal.
By contrast, an immediate annuity is a way to convert at least a portion of your retirement funds into a steady income that lasts as long as you do.
Characteristics of immediate annuities:
• One steady payment for life. "It takes away the anxiety that you may live longer than your money," says Steven Weisbart, an economist with the Insurance Information Institute of New York City, a nonprofit association financed by the insurance industry.
• They're simple. The company that provides the annuity handles the investment responsibilities.
• They're low-risk. That's assuming the provider is financially secure. The funds are guaranteed by the assets of the insurer and aren't subject to the vagaries of financial markets.
• They're tax-efficient. If you use tax-deferred vehicles to fund them, you only pay taxes on the checks you receive rather than on the entire lump sum.
So-called "qualified" immediate annuities are those that are funded by tax-sheltered accounts. That can include a distribution from a company retirement plan, an IRA or other tax-deferred retirement funds, such as a SEP. You can also transfer money from a deferred annuity into an immediate annuity. Payouts from a qualified immediate annuity are subject to taxes, of course.
However, if you are financing your immediate annuity with funds that have already been taxed, the amount of principal paid out each month is not taxable since that's considered a return of capital. In such cases, the annuity provider will indicate the amount of the monthly payout that would be excludable from taxes, generally at the time you receive a quotation.
Are annuities always appropriate?
1. Annuity Annie
Annie is a retired 65-year-old in excellent health with no children or heirs. She regularly exercises, does yoga and meditates. Annie eats a healthy diet and walks three miles a day to visit her 95-year-old parents, who are also in excellent health. Her money is mostly invested in low-yielding instruments such as bonds and a money market account.
An immediate annuity appeals to Annie. She'll have a guaranteed income stream and if she buys an immediate annuity with inflation protection, her annuity will offer a better rate of return than her previous investments.
2. No-annuity Nick
Nick, a retired banker, is an overweight 67-year-old with a history of heart disease and diabetes. He has a wife and a large extended family to whom he'd like to leave assets.
Nick is not a good candidate for an immediate annuity. He may want to set up an annuity for his wife after he dies because she would like the security of a regular monthly check and she is not as savvy as Nick about finances.
3. Middle-road Marvin and Mary
Marvin and Mary are married, in their early 70s with descendents. Both are in good health. Neither has a pension. They own mostly conservative investments: government bonds and CDs. Marvin is concerned their nest egg won't last. A financial planner advised the couple to diversify their savings by investing 25 percent in an annuity in Marvin's name only. The couple will also diversify some money in a moderately aggressive stock fund with an aim of boosting returns.
Source: Inspired by James Lange's 'Retire Secure!'
The biggest drawback of an immediate annuity is that the benefit normally dies with you.
"If you buy an annuity and then you get hit by a bus the following Tuesday, all that money is gone," says Michael E. Kitces, a Certified Financial Planner and director of financial planning for the Pinnacle Advisory Group in Columbia, Md.
An annuity that ends with your death may adversely affect your heirs. In fact, some financial planners won't recommend immediate annuities due to fear of lawsuits initiated by heirs.
Another downside of immediate annuities is that once the money is turned over, there's usually no turning back. Should you need a large sum due to illness or another emergency, you may be out of money and luck. "Once you've done it, you've lost access to the principal," says David Berman, a Certified Financial Planner with Berman McAleer based in the Baltimore area.
In addition, you won't have control over the sum you put into an annuity, and the guaranteed income that you receive from your immediate annuity may be less than what you might earn from another investment.
Of course, it's all relative. When the stock market was continually rising in the roaring '90s, immediate annuities looked like a poor bet. But when the Internet bubble burst and many retirees were forced to scale back (or even go back to work) because they lost huge sums in the ensuing bear market, immediate annuities started looking more attractive.
Financial planners emphasize that annuities should be just one item in your retirement toolbox that works well when properly used.
"It's a financial tool to manage risk," Kitces says. "If it's the tool you need, it's a great thing. If it's inappropriate, it's a terrible thing to use."
Annuities are good for retirees who are worried about their retirement savings running out and who are willing to forgo a higher return from riskier investments in exchange for a stable income. They're also suitable for healthy retirees who stand a good chance of living longer than folks of the same age group, but they're not suitable for the frail. Consumers who buy them are betting they'll live longer than actuarial projections.
When appraising immediate annuities, "You have to be honest about your own longevity," Lange says. "If I have a male client sitting here who is 30 pounds overweight and has a history of heart disease, I would tell him that he isn't a good candidate for an immediate annuity."
Most financial experts recommend that you don't sink all your retirement funds into an immediate annuity.
Because it is guaranteed -- you get the same amount each month regardless of how the stock market is performing -- investors get less of a "return" than if they would put money in high-yielding, riskier investments such as individual securities or stock funds. In the spectrum of investments, annuities are more conservative than equities but offer a better return than a bank certificate of deposit or government bonds. In any event, it's always a good idea to diversify among investments.
As a general rule, Lange, a CPA and tax attorney based in Pittsburgh, recommends allocating about 25 percent of your retirement funds into an annuity, but he warns that an individual should take his own personal situation into account.
"I don't think you should ever put all your eggs in one basket because you'll end up making an awful big omelet if something goes wrong," says Peter D'Arruda, author of "Financial Safari."
Although immediate annuities are primarily used as a vehicle for retirement, they may also be suitable for people who have received a settlement from a personal injury lawsuit, an inheritance from an estate or money from a divorce case.
Lange also sees immediate annuities as a way to leave money to heirs who aren't financially sophisticated. A mentally challenged daughter or a spendthrift nephew can benefit from an immediate annuity that is set up at one's death based on instructions left to the estate's executor.
As the buzz increases over immediate annuities, companies providing them are getting more creative and flexible with them, such as continuing payments beyond death. These variations have broadened their appeal.
Variations on the immediate-annuities theme:
• Set terms. Instead of buying a single-life annuity that lasts as long as you do, you can buy annuities for terms of five, 10, 15 years and so on. At the end of the defined period, the payments cease. If you die before the set period has elapsed, the annuity passes on to your heirs. (For example, if you die in the fifth year of a 10-year annuity, it would continue for an additional five years.) Generally a term-certain annuity will generate higher monthly payments than a single-life annuity and is useful for retirees who don't expect to live long.
• Survivor benefits. Married couples often buy an immediate annuity with a spouse benefit. Payments continue until the survivor dies. The disadvantage: Monthly payments are smaller than with a single-life annuity.
• Variable payments. Some immediate annuities allow subscribers to draw larger sums than their regular monthly stipend at set times (for instance on the anniversary of your purchase).
• Inflation component. You can add an inflation rider to your immediate annuity so payments keep pace with inflation.
• Variable rates. Payments on variable annuities are based on the type of investments you've chosen, unlike fixed immediate annuities.
Some immediate annuity contracts also allow you to withdraw some of the principal or cancel the annuity outright in case of an emergency. This flexibility comes with a price: lower monthly payments.
For married couples, D'Arruda suggests that rather than investing in a spouse benefit that lowers your monthly check, buy a single-life annuity plus a life insurance policy to finance the purchase of an annuity for your spouse, should he or she outlive you.
Insurance agents, financial planners, banks and life insurance carriers sell annuities. However, only life insurance companies actually issue policies, according to the Insurance Information Institute. Annuities developed by life insurance companies are often sold through banks, some investment management firms and stock brokerage firms.
It pays to shop around. According to Berman, annuities with a survivor benefit purchased today for a male age 70 would pay anywhere from $516 up to $769 per month based on a lump sum of $100,000.
Online calculators, such as the one at immediateannuities.com, give free quotes. For example, a 67-year-old woman living in Montana with $75,000 to invest in an annuity could receive up to $507 in monthly income without survivor benefits. That would drop to $497 if the annuity was designed to continue for five years after her death or $472 for an annuity that continues to pay out 15 years' guaranteed income for a beneficiary after her death.
In addition to finding out which company will give you the best payout, you'll also want to investigate the financial stability of a prospective annuity company. If the company is offering a killer payout but it goes under, chances are you'll outlive your annuity. Check with the four independent rating agencies -- A.M. Best, Fitch, Moody's and Standard & Poor's -- to gauge the health of annuity providers.
If you want to purchase an immediate annuity, but feel you are less healthy than average and won't live as long, take your case to your annuity provider, Berman says. It's the opposite of what you do with a life insurance company when you try to prove you're healthy and deserve a lower premium. Instead, you will want to prove to your annuity provider that you will likely live a shorter life on average so you deserve a higher monthly payout.
Finally, choose the immediate annuity that is most suitable for your individual circumstances. For example, if you want a 15-year annuity with inflation protection, choose a company that offers that type of annuity rather than settling for an annuity that doesn't match your needs.
Immediate annuities aren't for everyone and they shouldn't be the only vehicle in a retirement plan. Nevertheless they can supplement your retirement portfolio and at least ensure a steady income.