Income Forever

Annuity payments can cover your bills and let you invest more aggressively in retirement.

By Kimberly Lankford, Contributing Editor

From Kiplinger's Personal Finance magazine, March 2004

Like Mudville after Casey's last strike, there was no joy in Annuityland after last year's tax cut. By lowering the tax rate on long-term capital gains, Congress delivered one more blow to variable deferred annuities. Long criticized for their high fees, these investments also perform the reverse alchemy of turning tax-favored capital gains into highly taxed ordinary income. So the primary advantage of annuities -- tax-free compounding of earnings until they are withdrawn -- can be gravely undermined when those earnings are ultimately taxed in retirement at a rate as high as 35%, while profits in a taxable account enjoy the new 15% long-term-gains rate (or as little as 5% for taxpayers in the two lowest tax brackets).

But annuity isn't always a dirty word in retirement lingo. Immediate annuities, which you buy upon retirement to provide an income stream, are very different from the deferred annuities sold as a way to save for retirement. Immediate annuities can accomplish something that no other investment can: guarantee that you won't outlive your income, no matter how long you live.

This type of annuity is working perfectly for 73-year-old Janet Shugart of Citrus Heights, Cal. With longevity in her family -- her mother is now 95 years old -- Shugart was concerned that she might need to stretch her own retirement money over several decades. In 2003, she invested about $120,000 in a fixed immediate annuity and will get $925 per month for the rest of her life. "Our focus was to maximize income from her investment while she is alive, not to preserve the estate," says her daughter, Paula Willstatter, who helped shop for the annuity. "We chose to bet on a long life for her and purchased peace of mind for all of us with the annuity."

An immediate annuity can add stability to your portfolio in retirement, but don't tie up too much money. Once you buy an annuity, you generally can't get your money back, except via those monthly payments.

How much to invest?

The best way to figure out how much to invest in an immediate annuity is to work backward. First, add up your essential expenses -- your mortgage or rent, health- and long-term-care-insurance premiums, property taxes, utilities, food, and other bills you have every month. Then subtract guaranteed sources of income, such as social security and any pension payments. If there's a gap, consider plugging it with income from an annuity.

Note, however, that many advisers recommend investing no more than 30% of your assets in an immediate annuity. Shugart put about 20% of her retirement money in her annuity; the rest is in stock and bond mutual funds, and in savings accounts.

Knowing that your regular expenses are covered can give you the confidence to invest other retirement savings more aggressively. "A greater guaranteed amount of income allows for a tilt toward more growth-oriented stock investments," says Frank Gleberman, a financial planner in Marina del Rey, Cal. The combination can produce better overall returns than playing it safe with all your money, he says.

That's Stuart Wright's strategy. Wright, who spends a lot of time on the golf course near his Northridge, Cal., home, retired at age 60. He started taking social security payments at 62 and began tapping a T. Rowe Price immediate annuity the same year. He doesn't have a pension and wanted the regular checks to supplement his social security income. Instead of opting to receive checks for the rest of his life, though, he limited the payout to 15 years, no matter how long he or his wife, Diane, lives. This increased his monthly income by about $1,000, to $2,350. If he ends up living longer than that, he'll reassess the situation. "At that point, I'll be 77 and my income needs might be somewhat lower," he says.

Wright says knowing that his bills are covered frees him to invest the rest of his money more aggressively, in stocks. "If I to live to age 90, that's a long time from retirement to dying," he says. "If I were overly cautious, I might not have enough to last. My other assets should double in the next 12 to 13 years, and that's a very conservative estimate. At that point, I might buy another immediate annuity, or I might live off other principal."

Fixed versus variable

When you buy an immediate annuity, you have two choices -- fixed and variable. A fixed annuity guarantees that your monthly check will never change, no matter how long you live. This can be both good and bad. You know you'll always receive a certain amount, but the value of that fixed amount will surely be eroded by inflation. That isn't necessarily a severe problem, if you have other assets to cover rising costs.

Paul Johannsen, 56, who lives in Omaha, bought a fixed immediate annuity in 2002. He had just retired, and he used a lump-sum payout from his company retirement plan and a small piece of his 401(k) to buy an annuity with monthly payments of $2,376 -- enough to cover his basic living expenses. "It's automatically deposited in my checking account each month, which is convenient," he says.

In exchange for his $360,000 investment, Johannsen is guaranteed those checks for as long as he lives. His contract also calls for the payments to continue for at least 15 years, even if he dies before then, a provision that reduces the monthly payout a bit. "This will carry my wife, Trudy, into the time frame where she can withdraw social security," he says.

Despite the promise of guaranteed income, now really is not a great time to buy a fixed immediate annuity. "Keep in mind we are at a 40-year low on interest rates," says Patricia Brennan, a certified financial planner in West Chester, Pa. "Buying now will subject you to a historically low rate forever." For example, a 65-year-old man who invested $100,000 in a fixed annuity last year could have received as much as $737 in monthly income with a life-only payout. With today's miserly rates, he'd get less than $700 from most companies, according to WebAnnuities.com, which provides payout quotes for many companies.

If you need cash to cover your bills, consider tapping your nest egg for the next few months, then reevaluate the annuity option. That's what Brennan is recommending to her clients. "If and when interest rates rise, I will revisit the issue and perhaps lock in then." Another alternative is the variable immediate annuity, which ties your monthly check to the performance of investments inside the contract (you can usually choose from a variety of mutual funds). That means the size of your checks can rise to keep up with inflation through the years. Of course, it also means the payouts will shrink if your investments decline -- so you'll need a strong stomach, and other money to fall back on, during down years.

To see how a variable annuity works, consider a 65-year-old couple who invest $100,000 in a Fidelity immediate variable annuity that will pay out as long as either of them lives. The payout starts at $456 a month -- compared with a $582 monthly payout if they had chosen a fixed annuity at current interest rates. But that $582 payout from the fixed plan would have remained fixed, whereas the checks from the variable annuity could increase. If the investments earn an average of 8% a year over the next two decades, the payout will gradually rise to reach $682 per month. If the investments earn an average of 10% annually, the checks will be $968 per month in 20 years. The risk? The monthly payout will gradually fall to just $398 if the investments return only 5% and to $157 if the investments earn 0%.

This potential roller-coaster ride is a far cry from the guarantee of a fixed annuity, which explains why some retirees layer a variable immediate annuity on top of a fixed one, so they can have the potential for growth and a guaranteed floor. Others buy a variable annuity and keep the rest of their savings accessible to make up for any shortfall if the payout drops.

Tony Andreadis, 73, of Chestnut Hill, Mass., is in great health and expects to live a long time -- he's an aerobics instructor at the local YMCA. He wanted to make sure he wouldn't outlive his money, but he also wanted to keep up with inflation. So he bought a $60,000 variable immediate annuity from Fidelity nine years ago. "I told them, 'I'm going to live long enough to make money off you,'" he says.

The stock market has taken a wild ride since then, and Andreadis's quarterly checks (which started at $1,500), have risen as high as $2,700, and dipped back to $1,500 during the rough years. (He ended 2003 with quarterly payments of $1,680.) But he's not too concerned. "If I had put all of my investments in the annuity, I'd be very nervous," he says. "But there's enough diversity in my portfolio."

The rest of his money is in mutual funds, stocks and corporate bonds, and he's had plenty to cover his expenses, even in the tough years. "I have enough money that I'm not gambling with in other investments that I feel comfortable with the variable-payout annuity," he says. "I know the market grows. I'm in this for the long haul."

Having his regular expenses covered makes it easier for Andreadis to spend some of his other savings to help his grandchildren pay for college.

How to buy

It's easy to shop around for a fixed immediate annuity -- just compare the monthly payout amounts. A Web site such as WebAnnuities.com can give you payout quotes for several companies. Ignore the interest rate: One company may offer a higher rate but a lower monthly payout because of additional, embedded fees and greater life-expectancy assumptions. Also, keep an eye on the issuer's financial-strength ratings because you may need the company to pay you for three decades or more. For peace of mind, stick with companies rated A+ or better by A.M. Best or AA by Standard & Poor's.

It's trickier to shop for a variable immediate annuity. You can't just compare payout amounts because each company uses a different assumed interest rate (generally between 3% and 5%) to set the initial payment. The higher the assumed rate, the higher your first check will be -- but the tougher it will be for the income to increase over time. Ask each company for its assumed interest rate, and get projections for the same hypothetical return from several companies to see what happens to the size of the checks. Also compare fees and the performance of your investment options.

With almost all of the payout options, the longer you live, the better you'll do with an immediate annuity, so you need to ask yourself some tough questions about your health. If you don't think that you'll live beyond the average life expectancy, you may do better by holding on to your lump sum and withdrawing the money as you need it.

--Reporter: Joan Goldwasser

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