Annuities don't guarantee 'peace of mind'
Annuities may seem like a safe option when markets are volatile, but consider what you might be getting yourself into.
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (Money) -- I'm 60 years old and retired. I have an IRA worth about $400,000 that's invested in five mutual funds. The funds have done well the last couple years, but I am getting nervous about the market. I've been taking about $1,400 a month from the funds and am considering putting some of this money into an annuity for peace of mind. What do you think? --John Morrone, Steelton, Pennsylvania

Well, that depends on what you mean by "putting some of this money" into an annuity.

Essentially, you have two choices. One is to buy a "deferred" annuity, which means you invest your money and it earns a return that is free of taxes until you pull the money out, at which point your gains are taxed as ordinary income. You can do this with a "fixed" annuity, which pays a rate of interest much like a CD, or a "variable" annuity, which lets you invest in mutual fund-like portfolios called subaccounts. These types of annuities may offer some sort of protection against a market downturn, but you've got to be careful. That protection may not be all it seems, and to get it you may have to pay high fees or give up potential return.

The second choice is what's known as an "income" (aka an "immediate" or "payout") annuity. You turn over a lump sum to an insurer, and the insurer agrees to make payments to you, usually monthly, for a specified period. In the case of a lifetime annuity, you would receive those payments the rest of your life. Income annuities also can be fixed or variable. With a fixed income annuity, the payment you receive remains the same. With a variable income annuity, the payment changes depending on the performance of the "subaccounts" your money is in. Once you put your money in an income annuity, however, you lose access to your principal. Basically, you're giving up your cash for guaranteed income. (Okay, there are some annuities that will give you limited access to your principal, but they pay less income.)

Believe it or not, I've only given you the Cliff Notes version of annuities here. For more on how they work, click here. I've also left out another type of annuity known as an "equity indexed annuity" that's a hybrid of fixed and variables. For more on how they work, click here.

Getting back to your situation, if you're thinking about a deferred annuity as a way to insulate yourself from the market's ups and downs, then I don't think an annuity is a very good idea. For one thing, you don't need the tax deferral that annuities offer. You already get that within an IRA, and putting an annuity within your IRA would offer no additional tax benefit. More importantly, though, deferred annuities just have too many fees, expenses, complications and pitfalls. For example, most have surrender charges that can penalize you heavily for early withdrawals, although "early" may mean within 10 or more years.

So if what you really want is some shelter from a market setback, I'd suggest re-evaluating your mix of stocks and bonds, shifting more toward bonds and cash. I wouldn't overdo it, though, because at age 60, you're probably looking at another 25 to 35 years of life. You'll need some capital growth if you want your purchasing power to stand up to inflation.

If, on the other hand, you're looking to generate some income from your IRA portfolio, then you might consider putting a portion of your money into an income annuity. You would give up the assets that go into the annuity, but you could get a guaranteed income stream for life. And since you know that annuity check will be coming in every month, you can feel more confident about riding out any market turbulence with the IRA money you've still got invested in funds.

A couple of caveats. Annuity payments are based in part on your life expectancy. The younger you are, the lower the payment you'll receive. So unless you really need that income now, you're probably better off waiting to buy an income annuity. You can boost your lifetime monthly income by roughly 10%, for example, by buying at 65 rather than 60. That makes sense since a 65-year-old isn't likely to live as long as a 60-year-old, so an insurer can afford to make a higher payment. Of course, you could play this game by putting off buying year after year after year, only to find you've gone through your money in the meantime. So the aim is to buy the annuity when you want to start getting the income.

The level of interest rates will also determine your payment. The higher rates are, the higher your payment. What this means is that buying an income annuity is, in effect, making a bet on interest rates. (This is less true for a variable income annuity since your returns depend on the performance of your subaccounts, but let's not make things any more complicated than they already are.) If you buy when rates are high, you're locking in a fat payment. Buy when rates are low, you're locking in a skinny payment.

There's nothing you can do to influence interest rates. But one strategy that does make sense for people who want to get lifetime income from an income annuity is to buy a few annuities over time. This way, you decrease the odds of buying when rates are at a bottom. Buying over time means that some of your annuity payments will be based on an older age, which, all else equal, should also result in higher payments overall.

I know I've given you a lot to chew on here. So I suggest you read the stories I've suggested above. You should also take a look at an earlier story of mine that describes the advantages of having some of your money invested in mutual funds and some in an income annuity.

Even after doing all this, you may want to consider consulting an adviser (preferably one whose judgment isn't clouded because he earns part of his living selling annuities). An adviser can lay out your options and run some numbers showing how much income you might get and how long your portfolio could last under different scenarios.

That may take a little time. But when it comes to the retirement money it's taken you a lifetime to accumulate, you don't want to rush into a decision. And that goes double whenever annuities are involved.


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