3 Ways to Guarantee Retirement Income for Life
Insurers are rolling out a variety of annuities that they contend address baby boomers' desire for flexibility and choice.
Annuities can be a tough sell. Retirees and those approaching retirement worry that they will die long before they recoup their investment. Add to this concern the years of low interest rates and the industry's reputation for high fees, and it's not surprising that annuity sales are relatively flat.
But the annuity industry is convinced it can attract a growing wave of baby boomers who remember all too well the 2008 market downturn. Insurance companies are rolling out a variety of products that they contend address the baby boom generation's desire for flexibility and choice -- as well as a need for guaranteed lifetime income.
And it's likely that many retirees will give annuities a second look following the federal government's decision to give some products a thumbs-up. The Treasury Department in July changed the tax rules so people can invest some of their 401(k) and IRA money in certain types of annuities without having to take required minimum distributions on the money.
Still, even interested boomers may be befuddled by the choices. It may be wise to ask a financial adviser to help analyze various annuities to find the best fit.
You probably don't need to consider an annuity if you have a guaranteed income stream from Social Security and pensions to cover your fixed costs -- or a nice nest egg that's sure to deliver a solid cash flow for life.
Simple, Efficient Guarantees
The simplest way to guarantee lifetime income is an immediate annuity: You hand over a lump sum to an insurance company, and it promises to pay you a fixed amount of money every year for the rest of your life. If a 65-year-old man invests $100,000 in an immediate annuity now, he can receive $6,515 per year for life. The income is reduced to $5,292 if the payouts continue for as long as he or his 65-year-old wife is alive.
A big drawback: Payouts are locked in based on today's low interest rates, and they never change, with inflation cutting into the value. In 20 years, the $6,515 would have purchasing power of $3,600 in today's dollars based on an inflation rate of 3%.
One way to add some protection against the loss in value is to set up a "ladder" of immediate annuities. Instead of investing the entire $100,000 now, perhaps you invest $20,000 each year for five years. You could benefit two ways. Interest rates could rise in later years. Plus, annual payments rise when you invest at an older age. A 70-year-old man who invests $100,000 in an immediate annuity now would receive $7,560 per year in income.
An immediate annuity may be a good choice for someone without a pension who needs money to cover fixed expenses starting immediately. Sure, you'll need to make the initial investment, but if one of the 65-year-old spouses in the example lives at least 19 years, the couple will recover the initial cost, and the guaranteed payments would protect against any investment downturns.
If you have enough money to cover 15 to 20 years, an immediate annuity may not be the most cost-efficient way to protect against outliving your savings. Deferred-income annuities focus on the bigger risk if you live into your eighties or beyond. You invest money in your fifties or sixties, when you're newly retired or near retirement, and set a payout start-up date for at least 10 years in the future. The later the date, the higher the annual payouts will be. Longevity annuities refer to products with a 20- to 25-year deferral.
If you invest $100,000 in a New York Life deferred-income annuity at age 55 and start payouts when you retire at 65, you'll receive $10,116 a year for life, for example. If payouts start at 80, you'll get $39,357 a year for life. Wait until 85, and your annual payouts will be $75,882.
Deferring to your eighties, when you might need the money most, may make sense. But it can be tough to stomach psychologically: You'll likely wonder if you will live long enough to get the payouts. "The right way to think about longevity annuities is as insurance rather than as an investment," says Katharine Abraham, director of the Maryland Center for Economics and Policy at the University of Maryland, and co-author of a recent annuity study for the Brookings Institution.
Knowing you'll get bigger payouts for your later years may encourage you to invest your other assets more aggressively. "By locking in some income in retirement, you're able to pursue more growth with the rest of your portfolio," says Brett Wollam, senior vice-president for Fidelity Investments Life Insurance. The company sells several types of annuities, including five deferred-income annuities from top insurers.
If you worry about an early demise, you can buy a deferred-income annuity that provides a cash refund for your heirs. This annuity promises that either you or your heirs will receive at least as much money back as you originally invested -- in return for a lower annual payout. The New York Life annuity with the cash refund would pay the man in the earlier example $30,547 a year if payouts start at age 80. If he died before the second payment, his heirs would get the balance of his $100,000 investment -- $69,453.
But adding a cash refund may not be a good deal. Stick with the barebones deferred-income annuity if you want the biggest payout and have reason to believe, based on your health and family medical history, that you will be alive when the payouts are set to kick in.
New on the market are deferred-income annuities designed especially for traditional IRAs, 401(k)s and other tax-deferred retirement plans. Before the new Treasury rule, people were reluctant -- and some were unable -- to place deferred-income annuities in their retirement accounts because of required minimum distributions, which begin in the year you turn age 70 1/2. If your annuity payouts don't start until age 80, how can you take an RMD at 70 1/2 without cashing out the annuity? Because of the RMD rule, some insurers would only allow people to invest in annuities with money from taxable accounts, while others required that investors start taking annuity payouts at 70.
The new Treasury rule lets you invest up to 25% of an IRA or 401(k) balance -- to a maximum of $125,000 -- in a "qualified longevity annuity contract" (called a QLAC) without having to take RMDs on that money.
With a QLAC, an investor plunks down some cash at age 60 or 65 and gets relatively large guaranteed payments starting perhaps 20 years later. Because it will be "easier for people to buy longevity annuities with payouts starting at age 80 or 85, these new regulations are a really huge deal," says Abraham.
American General, Lincoln Financial, Principal and Thrivent recently started selling these products, and New York Life expects to roll out its product in the summer. Cathy Weatherford, president of the Insured Retirement Institute, a trade group of companies focusing on retirement income, expects at least six insurers to sell QLACs in the next few months.
Before you settle on a longevity product, compare offerings, says Jerry Golden, president of Golden Retirement Advisors, an annuity consultant. As new products come on the market, some insurers will be offering better payouts than others based on one's age and deferral period. Golden expects to launch a tool in May that will enable buyers to compare pricing from a variety of insurers based on different options. The tool will be available at www.go2income.com/qlac.
Michael Bartlow, a financial planner with Valic Financial Advisors, in Houston, says people have been asking him about QLACs as an IRA distribution avoidance strategy as well as for the income guarantees. By shifting up to $125,000 of your IRA or 401(k) out of the RMD calculation, you can reduce your income-tax bill.
Variable Annuities With Guarantees
Despite the simplicity of deferred-income annuities, many people are hesitant to hand over a lump sum to an insurer without an option for withdrawal. The variable annuity with income guarantees offers such an option. Later in life, you are likely to get higher payouts with a deferred-income annuity without a cash refund for heirs. But a variable annuity gives you the ability to withdraw your principal.
With a variable annuity, you basically have two parallel accounts: your investment account and your "benefit base." With your investment account, you invest in a menu of mutual funds offered by the insurer. Meanwhile, your benefit base, which is based on the initial investment, is guaranteed to grow by a certain percentage each year, typically 5% or 6% -- no matter how your actual investments perform.
The other guarantee is the percentage you can withdraw from your growing benefit base. Typically, you can withdraw 5% a year for the rest of your life starting at age 65, or 4.5% per year for joint-life payouts with a spouse, says Mark Cortazzo, a certified financial planner with Macro Consulting Group, in Parsippany, N.J.
Say you invest $100,000 at 55 and your benefit base is guaranteed to grow by 5% until age 65. (After 10 years, many annuities stop boosting the total size of the benefit base.) If you have a 5% withdrawal guarantee, you can get a payout of $8,144 a year on a total benefit base of $162,889 -- even if your actual investment declines. That's less than the deferred-income annuity's payout of $10,116 after 10 years in the earlier example. Plus, you have the option with the deferred-income annuity of boosting your payout even more -- $39,357 if you wait until age 80 -- which you cannot do with a variable annuity.
Of course, by waiting to start your deferred-income annuity payouts, you forgo years of annual $8,144 payments you would have gotten if you had opted for the variable annuity. However, at age 84, the deferred-income annuity pulls ahead of the variable annuity in total payments. And the gap grows bigger because the owner of the variable annuity will continue to get $8,144 a year, while the owner of the deferred-income annuity will continue getting $39,357 a year.
Still, says Fidelity's Wollam, a desire for flexibility and growth potential could come into play when choosing an annuity. "These types of preferences will drive the best choice for you," he says.
With a variable annuity, if your actual investments grow faster than the benefit base guarantee, your payout could rise -- so in the example above, you could eventually get a bigger payout than $8,144. Another advantage is that you have the flexibility to stop guaranteed payouts and take a lump sum from your investment account. When you take a lump sum, the annuity company will subtract from your investment account the total amount of your payouts. The size of the lump sum will depend on your investments' performance.
Variable annuities can be very complicated for investors to compare. "There are a lot more moving parts with the current offerings, and it is a lot more difficult to generalize than in the past," Cortazzo says.
Before choosing a variable annuity, compare the fees, surrender charges and investing options. Also, compare the guaranteed monthly payouts starting in the year you plan to withdraw. This analysis can be daunting to do on your own. Cortazzo's Annuity Review service ($299 to review up to two contracts, www.annuityreview.com) can help you compare options or figure out how to make the most of an annuity you already own.
Lynn and Frank Tracadas of Austin, Tex., recently asked Cortazzo to review a variable annuity with guarantees that they bought in 2008, right as the stock market started to fall. At that time, Lynn was 61 and Frank was 80, and they bought the annuity to provide lifetime income. They wanted to make sure the income could continue as long as either Lynn or Frank lived.
Because the couple bought the annuity in the midst of the market downturn, they originally invested the money conservatively, with 60% in fixed-income and cash. "We were in defensive mode," Lynn says. Knowing they had the guarantee, they gradually shifted more of their money in the annuity into more aggressive investments. If they keep the money in the variable annuity for a total of 10 years, the benefit base is guaranteed to double from their original investment and they can withdraw 5% of that money each year for the rest of their lives. "We have no intention to take the money out before 10 years," Lynn says.
When deciding which type of annuity -- if any -- is best for you, you need to look at your specific income needs and other investments. Two people of the same age with the same portfolio size may have different income needs based on their lifestyle, as well as their Social Security and pension streams.
First, estimate how much money you'll need each month in retirement to pay your essential bills, such as housing, food, transportation, insurance and health care expenses. Subtract any sources of lifetime income, such as a pension and Social Security. Then figure out how to fill in the gap, which could be from a combination of annuities and other investments.
If you're considering an immediate- or a deferred-income annuity, you can do some calculations at www.immediateannuities.com. You can plug in your current age, the year you would like payouts to start, and whether you would like an annuity to cover you and your spouse.