As rumors spread that President Obama might utter the word annuity during his State of the Union address earlier this year, the insurance industry went wild. Salespeople touted the president's impending seal of approval as a reason to buy their wares -- even if the high-fee, complex versions they were promoting only vaguely resembled the products that the president supports.
Although Obama never actually mentioned the A-word in his speech, his Middle Class Task Force later recommended annuities as a good way to reduce "the risks that retirees will outlive their savings or that the retirees' living standards will be eroded by investment losses or inflation."
The need for lifetime income is huge and growing as life expectancies continue to increase and traditional sources of guaranteed income disappear. For a 65-year-old couple, there's a 25% chance that one spouse will live until age 97, yet fewer people are retiring with pensions, and Social Security covers only a small portion of most people's expenses. Many retirees who had planned to fill the income gap with their savings are wondering where to turn after suffering through two severe market downturns over the past decade. An annuity may be the answer, but not all annuities are alike, and some may not be appropriate for you.
Plain and simple
An immediate annuity is based on a simple concept: You give an insurance company a lump sum and it promises to send you a monthly check for the rest of your life -- no matter how long you live. For example, a 65-year-old man who invests $100,000 in an immediate annuity today could collect $8,112 per year for the rest of his life. That's about twice as much as he could safely withdraw from his savings each year if he followed the widely accepted recommendation to limit initial withdrawals to 4% of your portfolio to avoid outliving your savings.
Part of the reason for the bigger annuity payout is that each distribution consists of interest as well as a return of principal. But the real secret behind the beefed-up annuity checks is that you pool your risk with other policyholders. People who die early end up subsidizing the payments of people who live longer. You get the biggest bang for your buck if you buy a "straight life" annuity, which pays out only for your lifetime, with no survivor benefits. But most married couples prefer to buy annuities that pay out as long as either spouse lives, even though it means smaller benefits. For example, a 65-year-old couple who invest $100,000 in an immediate annuity and choose dual coverage would receive an annual payout of $6,634.
Buying an immediate annuity helped Elaine Leaf stretch her retirement income. Ten years ago, Leaf, now 63, retired from a career in radio and moved from New Jersey to Edgewater, Fla. "I thought I could live on the funds from the sale of my house," she says. But she soon discovered she was wrong. Medical-insurance premiums alone cost $1,000 a month, and her investments took a major hit during the 2000-02 bear market.
Leaf took a job as a cashier at a discount clothing store to earn some extra money and qualify for health insurance -- but she was miserable. Her financial adviser recommended that she buy an immediate annuity from New York Life. She invested about $375,000 and now receives $2,500 per month -- twice as much as she was able to withdraw safely from her savings. (Because interest rates were higher four years ago, Leaf locked in a bigger payout than a 59-year-old could buy today.) "I feel protected for life," says Leaf. "Now I can count on a check that comes every month like clockwork."
How to shop
When deciding how much to invest in an immediate annuity, follow Leaf's lead: Add up your monthly expenses, subtract any guaranteed sources of income (such as Social Security and pension benefits) and buy an annuity to fill the gap. But watch out. Payouts can vary enormously by company, so it's a good idea to compare prices from many insurers. "There's easily a 10% to 15% spread from the top to the bottom of the list," says Hersh Stern, publisher of AnnuityShopper.com. Stern's Web site (www.immediateannuities.com) includes a database of more than a dozen annuity companies, making it easy to compare benefits.
One risk of immediate annuities, however, is that your fixed monthly check will lose purchasing power over time, so it's important not to tie up all your cash at once. Interest rates and your age at the time of purchase also affect the size of your monthly check. Because current interest rates are so low, you may want to ladder annuities, meaning you invest some money in an immediate annuity now and buy another one later when interest rates may be higher. Plus, you'll get a bigger payout because you'll be older and have a shorter life expectancy.
Another option is to buy an immediate annuity with inflation protection. Chris O'Flinn, of Elm Income Group (www.elmannuity.com), in Washington, D.C., recommends buying an annuity with annual payout increases linked to the consumer price index. Although the initial payouts are about 25% to 30% less than you would get by investing the same amount in a fixed annuity, you'll preserve your buying power. "When inflation comes, it tends to gallop in and stay around for quite a while," says O'Flinn.
Hedge your bets
Another way to deal with rising expenses is through a deferred variable annuity. (Despite the shared "annuity" label, the similarities end there.) Deferred variable annuities are complex products that try to do a lot at once. You invest in mutual fund-like accounts that can grow through time, and they give you a minimum guarantee in case the investments lose money. They're most attractive to preretirees in their fifties or sixties who want to capture stock-market gains during their final decade of work without exposing their nest egg to investment losses.
James Rogers, a financial planner in Exton, Pa., had avoided recommending deferred annuities for years, mainly because the distributions are taxed at ordinary income-tax rates rather than lower capital-gains rates reserved for most other investments. But Rogers took a second look when insurers started offering generous guarantees. "I found they really had some appeal to clients who have lived through two serious bear markets in the past ten years and have seen significant volatility in their portfolios," Rogers says. Clients who bought a deferred annuity with guaranteed benefits gained the confidence to remain invested in the stock market rather than stash their money in safe but low-return investments.
Rogers uses an annuity from Sun Life Financial that guarantees to increase the initial investment by 7% per year for up to ten years and then allows annuity holders who are 65 to 79 years old to withdraw up to 5% per year from that guaranteed base amount (or from the actual investment-account balance, if it is higher) for life. If you invest $100,000, for example, it would be worth $170,000 after ten years, at which point you could start withdrawing $8,500 per year. The company can afford to increase the guaranteed base by 7% for ten years, net of fees, because you can't take that cash in a lump sum. You can access only a small portion of that guaranteed amount every year, and the insurer is betting that it can earn more in the long run. You can withdraw only 4% of the guarantee every year if you start taking withdrawals when you are younger than 65, or 6% if you start when you are 80 or older.
In addition to offering investors both guaranteed income and a chance to let their account balances grow, deferred annuities are more flexible than immediate annuities, which generally require you to lock up your investment for life. You can cash out of a deferred annuity at any time, although you'll generally pay a hefty surrender charge if you do it in the first seven years or so. Cashing out an annuity would make sense only if your investments performed well and your actual account value was worth more than the guaranteed amount.
Unfortunately, annuities with guaranteed minimum withdrawal benefits aren't as good a deal as they were even a few years ago. After ratings agencies expressed concerns over insurers' ability to make good on their promises, many companies scaled back their guarantees and increased fees for new policyholders. When you add up the total cost of insurance, underlying investments and added guarantees, most deferred annuities cost between 2.5% and 3% per year of your initial investment amount. Many insurers also curtailed the investment options and now require you to invest a portion of your portfolio in a balanced fund rather than keeping all of it in stock funds. That minimizes their risk -- and limits your potential gain.
An alternative strategy
Mark Cortazzo, a financial adviser in Parsippany, N.J., has devised an alternative strategy to replicate the growth and income benefits of an annuity at a much lower cost. His clients invest some money in longevity insurance and the rest in a portfolio that he manages of low-cost exchange-traded funds.
In its purest form, longevity insurance allows you to buy an annuity now and begin receiving a generous payout for life starting in about 15 to 20 years -- assuming you live long enough to collect it. For example, invest just under $200,000 at age 65 and you could receive $50,000 every year for life starting at age 80. MetLife recently introduced a version of longevity insurance that provides extra benefits if you die early, for a relatively low cost. Cortazzo took notice and used it as a cornerstone to build a new model for retirement income.
Say you're 65 years old, married and have $1 million in retirement savings. You'd invest $277,000 in longevity insurance, which would pay out $50,000 per year, starting at age 80, for as long as you or your spouse lives -- or at least ten years, whichever is longer. That's a guaranteed minimum payout of $500,000 if you make it to age 80. If you and your spouse die before you turn 80, your heirs would receive your initial investment plus 3% per year for each year you or your spouse lived beyond the time of your initial investment. "Whether you live or die, it will be a profitable transaction for either you or your beneficiaries," Cortazzo says.
Cortazzo uses the remaining $723,000 of the $1-million nest egg to invest in an ETF portfolio composed of 60% to 70% stocks -- a bit more aggressive than a typical retirement portfolio -- with the balance in fixed-income investments. He charges 1.25% of invested assets to manage and rebalance the portfolio, including ETF fees. That's less than half the cost of a typical deferred annuity with guarantees. (If you're a hands-on investor, you could do it yourself for even less.)
Because your investment portfolio needs to last for only 15 years in this example -- until you can start collecting benefits from your longevity insurance at age 80 -- you can afford to take larger withdrawals than you could from a portfolio designed to last the rest of your life. According to Cortazzo's research and economic models, you could withdraw about $50,000 a year, or 7% of your assets. "You just need enough money to make it to the finish line at age 80," he says. And if the investments perform well, you'll have extra cash to supplement your longevity insurance or leave to heirs.
As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.
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