Create a Paycheck With an Annuity

New retirement-income products can help turn your savings into a reliable income stream.

EDITOR'S NOTE: This article was originally published in the March 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

The biggest financial challenge at retirement is to shift gears from saving to spending. Even if you diligently set aside money in good investments over the years, your retirement success will depend on how you turn that nest egg into a reliable income stream.

The big unknown: Will you run out of money if you live longer than you expected? In the past, pensions provided the major source of guaranteed lifetime income. But with fewer people retiring with pensions, the idea of including an annuity as part of a retirement portfolio is gaining support among financial planners, mutual fund companies, brokerage houses and the academic community.

To meet this need for predictable income, insurance companies are developing new retirement-income products. Even more significant, mutual fund and brokerage firms are providing nifty tools to help people calculate how to incorporate an annuity into their income plans. Until recently, these firms rarely included annuities in their asset-allocation recommendations for retirees. "An annuity can be an efficient vehicle, but it has to be the right person and the right amount," says Christopher McDermott, senior vice-president of investor education for Fidelity Investments.

Finding a way to provide guaranteed income could be crucial if retirees fear outliving their savings. "Many people do not understand life expectancy," says Noel Abkemeier, a principal at Milliman, a consulting firm. Average life expectancy for a 65-year-old male is 84.2 years, and it's 86.1 years for a 65-year-old female. But, says Abkemeier, "there's a 50% chance you could live longer than life expectancy -- and it could be 10 to 15 years more."

While some people ignore longevity risk, others try to protect their principal by limiting their spending to just 4% of their savings every year. That strategy can backfire if portfolio values plummet, as they did in 2008. If you don't know when you're going to die or if the market will sustain your withdrawals, then you need to look elsewhere for certainty, advisers say. "A big part of the art of financial planning is to take as many variables off the table as possible," says Christopher Blunt, executive vice-president in charge of Retirement Income Security for New York Life.

The first step in figuring out how to fit an annuity into an overall retirement plan is to use the calculators recently launched by Fidelity ( and MetLife (look for "Retirement Income Selector" at These tools will conduct a detailed analysis of your retirement savings, expenses and income. They will then help you decide how much of your portfolio you should put in stock and bond mutual funds and in cash. It will also calculate how much of your portfolio to invest in an annuity and the type of annuity it should be.

Annuities can be complicated and inflexible, and some have very high fees. You need to pick the product carefully and figure out the role it will play in your retirement portfolio. There are many types of annuities. Here's a look at the best kinds: immediate annuities, variable annuities with "living benefits," and longevity insurance.

Immediate Annuities

An immediate annuity guarantees stable income for as long as you live, or for a set amount of time. This product can stretch your retirement savings: Instead of the rule-of-thumb withdrawal rate of 4% annually, an immediate annuity can pay out 7% or more of your initial investment annually. A 65-year-old man who invests $100,000 in an immediate annuity can receive up to $7,776 a year for the rest of his life, or $8,772 if he invests at age 70, says Hersh Stern, who runs

In return for those high payouts, you give up access to the principal. Those payments stop when you die. In most cases, that payout remains the same for the rest of your life. That can be both a blessing and a curse: You know exactly how much income you'll get, but the purchasing power will shrink with inflation.

Because of these downsides, you only want to invest a portion of your money in an immediate annuity -- never more than 50% of your net worth, says Fidelity's McDermott, and often much less.

To calculate the amount, add up your essential monthly expenses in retirement, such as housing, food, utilities and insurance. Then subtract any sources of guaranteed income, such as Social Security and a pension, and buy an annuity that provides income to fill any gap. Keep the rest of your money in an emergency fund and in investments that can grow over time.

Before James R. Montgomery III, now 79, retired to Ponce Inlet, Fla., he was an actuary and former insurance commissioner for the District of Columbia. He bought an annuity for his wife nine years ago to cover the gap between his pension and Social Security and their expenses. The annuity would also provide extra income if he died first and his pension benefits shrunk. "Many investment advisers tell you to draw down 4% per year and keep your fingers crossed," he says. "I like the guarantee aspect. I wouldn't suggest spending your last penny on an annuity, but it's certainly important."

He chose a single-life annuity for his wife rather than a joint-life annuity, which would have provided lower payouts but would have covered both spouses as long as they lived. Montgomery wanted to maximize the payouts for his wife, because he would have enough money from his pension if she were to die first.

Now age 77, his wife bought another annuity this year to fill in additional gaps. The couple kept her family's longevity in mind when deciding to buy an annuity at that age. "Her mother lived to be 100," Montgomery says. "I'll bet on that."

You can account for inflation by building an annuity ladder. The older you are when you buy an annuity, the higher the payout. Rather than buying a single annuity at one time, you spread your investment over several, generating higher payments as you get older.

Or you can buy an immediate annuity with payouts that increase over time, either with the consumer price index or by a fixed amount, such as 2% or 3% a year. However, the initial payouts start about 25% to 30% lower than they do with fixed-payout annuities. For example, a 65-year-old man who invests $100,000 in a New York Life immediate annuity without an inflation adjustment could get $6,930 a year for the rest of his life; an annuity with a 3% annual increase would start with an annual payout of $5,168 at age 65 and grow to $6,743 by age 75, $7,818 at 80 and $9,063 at 85.

The payout amounts for an immediate annuity can vary by company. When Montgomery shopped around, he found that one company was charging $13,000 more than another for the same payout. He bought his annuity through, which provides price quotes from dozens of insurers.

Variable Annuities With Living Benefits

These annuities are a combination of tax-deferred savings and insurance. You invest in a portfolio of mutual funds. In most cases, you don't tap the money for several years, giving the underlying investments time to grow. These products guarantee that you'll be able to withdraw at least a certain amount of money each year for the rest of your life, even if the market tanks.

Many of these products are complex and expensive. But a new simplified product sold jointly by Fidelity and MetLife topped $1 billion in sales the first year, which ended in November. If a 65-year-old man invests in the Fidelity/MetLife Growth and Guaranteed Income annuity, he will get at least 5% of his initial investment each year for the rest of his life -- $10,000 a year on a $200,000 investment, for example.

The money is invested in a Fidelity portfolio of 60% stocks and 40% bonds, and your minimum guarantee rises if your investment increases. If your investment grows faster than your withdrawals, your annual payouts can rise. But if your investments plummet, you're still guaranteed the minimum payout you locked in. "We tried to make it simple," says Jeff Cimini, president of Fidelity Life Insurance. "It's hard for folks to determine how to meet their expenses if they don't know what the income is going to be with the products they have." The annuity charges a lower-than-average fee of 1.9% for a single-life annuity and 2.05% for joint life.

The Fidelity/MetLife product actually never annuitizes. You can withdraw the value of the underlying investments at any time. But if you need to tap some of the investments early, perhaps for unexpected medical bills, you may lower your future guaranteed payments.

These variable annuities can be layered on top of immediate annuities in your retirement-income portfolio. You can cover some of your early expenses with an immediate annuity, while allowing the deferred variable annuity to grow and cover rising expenses later.

Variable annuities can also be attractive to people in their late fifties or early sixties who plan to retire in a few years and worry about a big market drop just as they're about to start taking withdrawals. They want to keep money in the stock market for future growth, but they also want to lock in a guarantee now. "They're in the homestretch, and they may not have the emotional fortitude to withstand a downturn," says Matthew Jarvis, a certified financial planner in Seattle.

Most of Jarvis's retired clients invest in a balanced portfolio of mutual funds and exchange-traded funds with a five-year cash buffer. But he explains to clients the option of the variable annuity with lifetime benefits if they worry that their nest egg won't last for the long term. Jarvis also explains that the safety of the annuity will cost two percentage points more each year than if he manages the portfolio of funds.

Last year, Bruce Kannenberg assessed his options and chose a variable annuity with living benefits. He will turn 64 in May and plans to retire from Weyerhaeuser in Federal Way, Wash., in three to five years. In the early days of the market downturn in 2008, he switched 85% of his investments to cash just before the market hit bottom. "Keeping all cash is not good for the long haul, but we were concerned about preserving the money we had set aside for retirement," he says.

Kannenberg sought help from Jarvis, who showed him a Prudential annuity with a guaranteed minimum withdrawal benefit. "The annuity gave us a happy middle ground between the safety of cash and the growth potential of equities," says Jarvis. Kannenberg and his wife, Cynthia, 58, invested about 35% of their retirement savings in the annuity.

With the Prudential annuity, there are basically two pots of money -- an investment pot and a guaranteed pot. Let's say you invest $100,000. That money will go into an investment pot of mutual funds, and it will go up or down depending on the market.

But the $100,000 will also be the baseline for the guaranteed pot. For every year you wait before you start taking payments, the $100,000 will "grow" by 5% a year. (Kannenberg bought the annuity when the rate was 6%.) Let's say in year six the guaranteed pot is worth about $135,000 and you decide to start taking monthly withdrawals. You can withdraw 5% of $135,000 each year for the rest of your life.

Meanwhile, the investment pot is actually worth $120,000. If you need extra cash, you can take all or part of your actual investment (you also may need to pay surrender charges). But you will lose the 5% yearly guarantee.

However, let's say your actual investments exceed the $135,000 in the guaranteed pot at the time you decide to take guaranteed payments. Perhaps your investments in mutual funds are now worth $150,000. You can lock in the guaranteed payment of 5% a year based on the $150,000.

Finding a good variable annuity is more difficult than choosing an immediate annuity. Read the prospectuses, and compare the fees, surrender charges and specific guarantees.

Longevity Insurance

The newest trend in annuities is known as longevity insurance. These are super-deferred annuities that start paying out at about age 85. Academics love longevity insurance because it does the most efficient job of guaranteeing that you won't outlive your savings.

With longevity insurance, you pay relatively little for a big payout down the road. MetLife and New York Life are two of the handful of companies offering this product. If a 65-year-old man invests $50,000 in one of MetLife's longevity insurance products, he'll get back $35,205 a year in monthly payments starting at 85 for the rest of his life.

Very few people are buying these annuities because retirees are not sure they will live long enough to get any money. Some versions have a small death benefit, but in return for a lower payout.

But longevity insurance will maximize your retirement income at a time when you may need money to pay for long-term care and other medical expenses. It is best if you think about it as insurance against living too long, rather than as an investment that may never pay out. Abkemeier recommends investing no more than 10% of your portfolio in longevity insurance, so you'll have plenty of money for your other needs.

MetLife includes longevity insurance in its retirement-income calculator, which makes it easy to see how it can fit with your other retirement investments. "I think longevity insurance is a very powerful, transparent, lower-cost product that is misunderstood," says Robert Sollmann Jr., executive vice-president of retirement products for MetLife.

Sollmann notes that by knowing that this safety net is in place, you can be much more flexible in investing money for the earlier years. Perhaps you can withdraw more or you can use some of the freed-up money to buy life insurance for your heirs.

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