Annuities – How Not to Run Out of Income in Retirement

Running out of income is the biggest fear of most retirees. Annuities often are the best way to avoiding running out of income. Yet, few people take advantage of this opportunity, and many who do buy annuities make the wrong decisions.

That is because annuities are complicated, and commissions can give sales people the wrong incentives.

This should change. New regulations are being put in place by the states to limit deceptive and abusive sales practices of annuities. This should make annuities clearer and more consumer friendly and enable investors to increase their financial security by using annuities when appropriate.

Let’s take a look at different annuities and which can best ensure lifetime income.

An annuity can be fixed or variable. A fixed annuity pays a fixed rate of interest. Actually, the rate changes, usually every year. But it is set by the insurer and is known for the next period. The interest rate usually is similar to that of intermediate-term corporate bonds, but there is little risk that the account’s balance will decline as stocks and bonds can. A fixed annuity can substitute for bonds in a portfolio.

A variable annuity is invested as directed by the account owner among mutual fund choices made available by the insurer. The returns for the account will vary with the returns from the investments. Returns can be negative.

variable annuities have several layers of fees. There are some low-expense variable annuities, such as one offered by Vanguard, but most variable annuities have high fees. With any variable annuity, the fees will be higher than from owning mutual funds in a taxable account.

The advantage of either type of annuity is that the investment income compounds tax-deferred in the annuity. But the income is taxed as ordinary income when withdrawn.

If long-term capital gains from mutual funds are earned in a taxable account, the maximum tax rate is 15%. But if the funds are held in a variable annuity tax-advantaged gains are converted into ordinary income.

Because of the higher costs and potential tax disadvantage, a variable annuity should be purchased only by someone who will invest for a relatively high rate of return and who can let the account compound for at least 12 years. The investor also should have exhausted all other tax-advantaged investment opportunities, such as 401(k)s, IRAs, and Roth IRAs.

A third type of annuity, the equity indexed annuity, is a hybrid of the other two. The EIA is discussed in detail in the Annuity Watch section of the Archive on the web site.

An annuity also can be either deferred or immediate.

An investor makes investments in a deferred annuity in either installments or a lump sum. The investments are put in the account, and the earnings compound tax deferred over time. Fixed, variable, and equity-indexed annuities all can be deferred.

There usually are several options for withdrawing money from a deferred annuity. The account can be withdrawn in a lump sum, as unscheduled periodic withdrawals, or as fixed, scheduled payments. The last method is known as annuitization.

An immediate annuity begins payments within one year after the investor purchases the annuity, and the payments are on an annuitization schedule.  The payments usually are scheduled over the life of the owner, the joint life of the owner and spouse, or the longer of life and a term of years. For example, payments might be scheduled for the owner’s life or 10 years, whichever is longer. That way, if the owner dies prematurely, a beneficiary gets some income from the annuity.

Immediate annuity payments usually are fixed for life. There are some annuities that make variable payments. These were discussed in the November 2005 issue, and the article is in the Annuity Watch section of the Archive on the web site.

Immediate annuities are the best way to replace the rapidly-disappearing company pension. A portion of an individual’s retirement assets can purchase an annuity. The steady, guaranteed stream of income replaces the steady income most retirees used to receive from a company pension.

Many investors are hesitant to use immediate annuities. The biggest complaint is that there is no guarantee of receiving a return of the annuity’s principal. If the owner dies after less than his life expectancy, the insurer keeps the account balance. The heirs of the owner would have been better off if the annuity had not bee purchased.

This problem can be averted by choosing a distribution schedule of the greater of life or a period of years or for the joint life of the owner and a beneficiary. But that reduces the payout, and could reduce it substantially.

It is better for an investor to realize that an immediate annuity is not intended to provide for heirs. It is to provide security for the owner. Other assets or life insurance can provide for heirs.

An investor should not consider putting all or even most of his retirement assets in an immediate annuity. Instead, put one third or less of the portfolio in an annuity. The annuity is to provide a secure floor on retirement income, not to provide all retirement income or to provide for heirs.  Other assets are needed to provide additional income and to ensure inflation protection. Providing for heirs should be considered only if there is enough money.

There are a couple of ways to get the advantages of an immediate annuity and reduce the disadvantages:

• Delay your purchase. Do not buy the immediate annuity until age 70 or later. The later the annuity is purchased, the higher the payout will be. A later purchase also reduces the likelihood that an early demise makes the insurer a big winner because of the higher payouts. The age 70 or later purchase makes sense because of longer life expectancies. It makes sense for an individual to invest and withdraw assets from the investment portfolio until then. Only after age 70 use part of the portfolio to purchase the security of an annuity. 
• Make installment purchases. You do not have to sink a chunk of your portfolio into an immediate annuity at one time. Instead, put a portion of the assets into an annuity each year between ages 70 and 80. The guaranteed income increases each year as a new annuity is purchased. This strategy also gives the investor the opportunity to stop the purchases. If there are health setbacks, he might conclude that further annuity purchases would not be a good deal and that the assets should be protected for heirs.