Guarantee a comfortable retirement

If you're concerned that income from Social Security and pensions might not be enough to give you the retirement lifestyle you want, consider an immediate annuity.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

NEW YORK (Money) -- Question: I expect to have about $50,000 in pension and Social Security benefits when I retire. Do I need to buy an annuity or should I just keep investing in stock and growth and income funds? --Michael, Columbus, Georgia

Answer: I hate to start an answer with what is probably the most overused phrase in financial journalism, depends.

It depends on how large you think your expenses will be in retirement, how much money you want for unexpected expenses and emergencies and how much you want to leave to heirs.

A good start is to ask yourself how much of your expected retirement expenses you want to cover from guaranteed sources of income like a pension, Social Security and annuities. There's no official correct percentage, but one strategy is to cover as much of your essential expenses -- housing costs, food, basic transportation -- as possible from secure sources. That way, you know that, whatever else happens, you can maintain a minimum acceptable standard of living.

So if you feel $50,000 from your pension and Social Security will cover enough of your basic expenses to give you the comfort level you need, then you probably don't need any more guaranteed income, which means no annuity.

But what if you feel that your basic expenses are running higher than $50,000? Or maybe you want a cushion for inflation. (Yes, Social Security provides cost-of-living increases, but most corporate pensions don't.)

Guaranteed income for life

You might want to devote a portion of your savings to a lifetime immediate annuity. Annuities come in many variations, some of which (make that most) can get pretty complicated. But an immediate annuity is the easiest type to understand. You hand over a chunk of money and in return you get a guaranteed monthly payment for the rest of your life (or, if you wish, as long as you or your spouse is alive).

A 65-year-old man who puts $150,000 of his savings into a lifetime immediate annuity would get about $1,025 a month, or $12,300 a year, for the rest of his life. Assuming he was starting with $50,000 like you, that would boost his guaranteed income to more than $62,000. A 65-year-old couple, on the other hand, would get about $840 a month, or just under $10,100 a year. Yes, that's less what a single person gets, although that income would be paid as long as either member of the couple is still alive.

You should know that if you buy such an annuity, you would no longer have access to that $150,000. You've turned it over for guaranteed monthly payments. So even if you feel you do want more guaranteed income, you want to be careful about how much you devote to an annuity. You want to be sure you have enough savings left for emergencies and such. If you plan to leave money to your heirs, you must also take that into consideration.

One way to exercise caution is to "annuitize" a bit of money at a time. Instead of doing $150,000 all at once, maybe do $50,000 initially, which would give a single 65-year old man roughly $340 a month, or close to $4,100 a year. You could then do another $50,000 a year or two later if you feel you need more guaranteed income, and another $50,000 later still if you want still more.

Annuitizing in stages can have several benefits. Since annuity payments hinge partly on interest rates, it can prevent you from locking in all your money when rates are low. In effect, you're diversifying your interest rate exposure.

Annuity payments are also determined by your age. All else equal, the older you are, the higher your payment. So barring a change in interest rates, a 70-year-old man purchasing a $50,000 lifetime immediate annuity might collect about $388 a month, or nearly $4,700 year, or about 13% more than a 65-year-old. A 70-year-old couple would see a comparable increase.

Buyer beware

Now I'm sure that there are a lot of people out there saying, "Yeah, but why bother buying an immediate annuity? I can get a higher payout managing the money on my own. And besides, what if I die soon after buying it? I'll have collected only a handful of payments and my heirs will get zip. Won't I have wasted my money?"

On the first objection, sure, maybe you could do better on your own. But it's not likely. Why? Because annuity payouts also include an extra kick that you could call a "mortality return." Insurers know that some annuity buyers will die before life expectancy. The money that would have gone to them is essentially transferred to the annuity owners who live longer. That boosts the effective return.

To match it, you would have to take on more investing risk, which might pay off. But it might not. If it doesn't, you could end up running out of money earlier than you expected.

As for the reluctance to buy an annuity because you might die early, that's understandable. An annuity is a much better deal if you live beyond life expectancy, since you'll collect payments for a longer time. So if you really know you're likely to have a short life span, a lifetime immediate annuity isn't for you.

But how many of us really know that? The point is that a lifetime immediate annuity is a form of insurance. But rather than protecting against the risk of dying early, as life insurance does, it protects you against the risk of dying late, or living too long. Is the money squandered if it turns out that, despite your expectations for a long life, you depart for the Great Beyond ahead of schedule? I'd say no, that money isn't misspent any more than the money you've spent on medical insurance if it turns out that no one in your family develops a long-term illness that's expensive to treat.

Invest your age

Whether you buy an annuity or not, I recommend that you re-assess how you invest the rest of your savings. You indicate that you're now in stock and growth and income funds. What you don't mention are bonds or bond funds.

Remember that as you approach retirement -- and certainly once you're retired -- an all-equity portfolio can be pretty risky. If the market takes a dive like it did last year -- or drops by even half as much -- a portfolio invested entirely in stocks could get whacked pretty hard, and may have trouble recovering and thus jeopardize the chances of your savings lasting throughout retirement.

I suppose your growth and income funds contain some bonds. (You can find out with Morningstar's Portfolio X-Ray tool.) But the chances are good you're invested very heavily in stocks.

So you might want to consider rounding out your holdings with a broadly diversified bond fund or two. (For candidates, check out our Money 70 list of recommended funds.)

I can't give you an exact percentage of your portfolio that should go into bonds. But at 65, a 50-50 mix of stocks and bonds is a reasonable starting point.

Bottom line: I believe that an immediate annuity may be able to play a valuable supporting role in the portfolios of many (although certainly not all) retirees. But you can't know if you're one of them until you've thoroughly considered the issues raised here. To top of page

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