Buy a Pension With an Immediate Annuity

For the overwhelming majority of investors, especially seniors, annuities make no sense. But one kind of annuity works beautifully for many retirees.

Far too few people buy these annuities -- because salespeople can’t earn much selling them and because the personal-finance media have soured savvy investors on annuities.

I’m talking about immediate fixed annuities. When you buy an immediate fixed annuity (henceforth, I’ll call it an IFA), you buy yourself a pension (see Do-It-Yourself Pension). You give the insurance company a lump sum, and it sends you a check every month for a guaranteed amount for the rest of your life. When you die, the insurance company keeps anything that’s left of your premium. Think of an IFA as term life insurance in reverse -- the longer you live, the better you do.

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The monthly payments are generous. For example, a 76-year-old man who came to me for advice was offered a 10.6% annual return on an IFA. In today’s low-interest-rate environment, that’s much better than he could do in all but the riskiest bonds. It’s also probably better than he could do if he put all his money into stocks. There is a catch: With an annuity you don’t get your money back.

Why such big payments? The insurance company pools premiums from thousands of annuities and invests them primarily in bonds. The company also makes educated guesses about how long annuity buyers will live. Then it makes monthly payments to policyholders each month based upon both expected longevity and expected investment returns.

IFAs usually make sense only for retirees. The older you are, the fewer years, on average, the insurance company will have to pay you benefits -- so the bigger your monthly checks.

For many people, age 65 is a good time to begin considering IFAs.

Think of an annuity as a place to put some of your bond money or cash. A typical retiree may hold 40% to 60% of his or her assets in bonds yielding 5% or less, with the rest in stocks. You could boost your income significantly by putting, say, two-thirds of the bond money into IFAs. A 65-year-old man can earn 7.4% annually on an annuity. A 70-year-old woman can earn 7.9% a year. And a 75-year-old Florida couple can earn 9.1%. (These rates apply to all states except about five, including California and Nevada, which tax premiums, meaning you receive a slightly lower monthly payout.)

Insurance companies usually make hefty profits on their products, and they certainly don’t give away IFAs. But it’s difficult to mark them up much because consumers can so easily compare one company’s IFA against another’s. They’re like term life insurance in their simplicity.

How to buy annuities

The best place to start your search is at ImmediateAnnuities.com (800-872-6684). Plug in the state you live in, your age and your gender, and the Web site instantly spits out quotes from numerous companies. You can often get a better deal through Vanguard (800-357-4720). If you or a relative has been in the military, also check out USAA (800-531-8722). Some credit unions also offer low-cost annuities.

But don’t jump in all at once. The higher bond yields are, the more you’ll collect from an IFA -- and I don’t have to tell you how low yields currently are. No one can accurately predict with any consistency when yields will change or by how much. So the smart approach is to invest relatively small amounts in an immediate annuity every couple of years or so.

Make sure, of course, to buy from a company that holds a top credit rating from A. M. Best. You don’t want the company you buy an annuity from to go bankrupt. That’s why it’s a good idea to spread your purchases among several different insurers.

Annuities don’t make sense for everyone. If you’re in poor health, you may not earn enough to compensate for your initial investment. Money you invest in an IFA is immediately gone -- you can’t get it back for any reason. You certainly can’t leave it to your heirs. That’s why annuities seldom make sense for all of an investor’s money.

Insurance companies offer a variety of options to suit your needs. You can buy an annuity that guarantees that your heirs will get a portion of your initial investment if you die within a certain time. You can also buy an annuity that boosts your payments in line with inflation. Obviously, an annuity with a cost-of-living adjustment will cost more than one without a COLA.

I’d generally steer clear of these embellishments. They complicate the annuity, making it harder to comparison shop. They also shrink your monthly payments. Inflation protection is a good idea in theory, but relatively few insurers offer it, so there isn’t much price competition.

There is one extra that is often worth having. You can buy an annuity that lasts as long as either you or your spouse lives.

The trick to making immediate fixed annuities really pay off is one all of us would like to accomplish: Live to a ripe -- and healthy -- old age.

Steven T. Goldberg is an investment adviser.