When is an annuity worth it?

(Money Magazine) -- Question: I just don't understand annuities. There seems to be a lot of buzz about their guaranteed income as a crucial piece of any retirement portfolio. But if I have $100,000, then I already have guaranteed cash to pull from that is not subject to fees or penalties. And I may benefit from higher interest rates in the future. So why would I buy a $100,000 annuity? What am I missing? -- Dave, Denver, Colorado

Answer: Winston Churchill once described Russia as "a riddle wrapped in a mystery inside an enigma."

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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).

Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
• Getting help

As far as many investors are concerned, he might just as well have been talking about annuities. They're probably the single most misunderstood investment around, in large part because there are so many varieties of them, many of which contain arcane features that can numb the brain.

So if you do nothing else, I suggest that you check out the annuities section of our Ultimate Guide to Retirement.

In the meantime, I'd like to answer your question, not so much to tell you categorically that you should invest in an annuity, but to suggest why you might want to consider putting some of your money into a particular type of annuity known as an immediate annuity.

Let's start with your $100,000. You don't say how old you are, but just so we can use specifics, I'll assume you're 65.

If you put that hundred grand into an immediate annuity today and select the lifetime income option, you would receive about $660 a month for the rest of your life.

The amount of lifetime income an annuity pays depends mostly on your age and the level of interest rates when you buy. But the size of the payments will also vary somewhat by insurer, with some companies paying more, others less.

As you note, rather than buying an immediate annuity, you also have the option of investing your $100,000 on your own and drawing income from your stash. If go this route and want a high level of assurance you'll get income for life, you'll likely want to keep your money in something that's very secure, such as long-term Treasury bonds, which recently yielded about 4.6%.

So let's assume that instead of getting an annuity, you invest your money in a pool of Treasury bonds and then systematically withdraw enough principal and interest each month to duplicate the annuity's $660 monthly payment.

If you did that, however, you would run out of money before you hit age 84. If you wanted to assure that your $660-a-month payments would last until age 85 -- roughly the life expectancy for a 65-year-old -- you would have to invest $105,000 in those Treasuries.

But approximately half of people live beyond life expectancy. And if you wanted to count on those $660 monthly payments coming in until age 95, you would have to put just over $130,000 into Treasuries. Live beyond 95, though, and you'll run out of dough. The annuity, on the other hand, pays as long as you live.

How, you may ask, can an annuity make these larger payments and guarantee them for life? The answer lies in what are known in insurance circles as "mortality credits." Insurers know that some people who buy annuities will die before life expectancy, while others will live longer. That allows insurance companies to increase annuity payments by essentially transferring the money from the people who die early to those who die late.

Of course, you could try to boost the income you get from your $100,000 or the period of time it will last (or both) by investing in assets, such as stocks, that have a higher return potential than Treasuries.

But that would subject you to greater risk. If things work out in your favor, you might do fine. But if you run into rocky markets and take some losses -- especially early in retirement -- the combination of investment losses and withdrawals could deplete your portfolio pretty quickly.

As for your comment that by holding onto your $100,000 rather than buying an annuity you "may benefit from higher interest rates in the future," that's true. But the operative word is may. Maybe rates won't rise and you won't benefit.

Even if rates do go up, it's not a given you'll end up with more income. It depends on how you invest.

If you invest in something like a money market account or short-term CDs, then rising rates would translate into more income (although in the meantime, you'd have to draw out much less than with an annuity given the low yields of money market accounts and CDs). But if you invest in stocks and bonds, rising rates would likely reduce the principal value of your portfolio.

So to reinvest your money to take advantage of higher rates, you would have to sell your existing investments at a loss, leaving you with less to reinvest. I doubt you would be better off, and you might be in a worse position.

Even the Treasury scenario I gave above probably overstates your ability to duplicate what an annuity does. Why? Well, at current yields, $100,000 in Treasuries won't throw off anything close to $660 a month. Which means you'd have to sell off Treasury bonds periodically to match the annuity's income.

You'd then run into the issue of what price you'd get when you sell. If rates have gone up, the market value of the bonds would fall.

Once you buy an immediate annuity, you get guaranteed lifetime payments but typically lose access to your principal. So you can't tap that $100,000 for emergencies and such.

Plus, the insurer you're relying on to make those annuity payments years into the future could run into financial problems, jeopardizing your income.

And let's not forget what I call the "rogue bus scenario" -- i.e., the worry that shortly after buying the annuity you'll get hit by the proverbial bus. In that case, you'll have shelled out big bucks, gotten only a few payments and left nothing to heirs.

But I think these issues are pretty easily dealt with. How?

By putting only a portion of your money into an immediate annuity, you have a stash that can provide liquidity for emergencies. You can also invest for long-term growth so you can maintain your standard of living as you age.

How much is enough? That depends on individual circumstances, but one guide is that you may want to devote enough to an annuity so that the combination of payments from Social Security, any traditional pensions you have plus the annuity income cover the bulk of your basic living expenses.

When it comes to protecting yourself against the possibility of an insurer being unable to make annuity payments, there are several lines of defense. You can stick to insurers with high safety ratings. You can also diversify -- that is, split whatever money you're planning to "annuitize" among the annuities of a few insurers.

And you can make sure that the amount you invest in an annuity with any single insurer is within the maximum covered by your state's insurance guaranty association. (By spreading out your purchases over time, you can also diversify against the risk of putting all your dough into an annuity when interest rates are abnormally low.)

As for the idea that you've wasted your money if you die soon after buying a lifetime annuity, that money is no more "wasted" than the money you paid to insure your house even though it never burned down.

Which brings us to the central difference about generating income from your savings by yourself vs. buying an annuity: unless you're willing to take more investment risk, you as an individual can't match the guaranteed income an immediate annuity can provide.

This is probably one of the few statements that you can get most economists to agree on, as two Wharton finance professors pointed out in this policy brief on investing for retirement.

Bottom line: you may already have "guaranteed cash" in the form of $100,000. But there's a huge difference between that and having guaranteed income for life.