Bridge income gaps with an annuity

By Walter Updegrave, senior editor

(Money Magazine) -- Question: My husband recently retired and we are in the process of deciding how to invest the money in his 401(k). He and I both have good pension plans and I plan to work at least another five years. We have been advised to invest two-thirds of my husband's 401(k) assets in annuities, but I'm comfortable with putting only a third in annuities. Any advice? -- Jean, Omaha, Nebraska

Answer: Before you start negotiating with some adviser about how much of your husband's retirement savings should go into annuities -- Two thirds? A third? Do I hear seven-sixteenths? -- you should step back and ask yourself a few key questions.

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).

Like, why are you considering investing in an annuity in the first place? What are you hoping it will do for you? How does it fit into the rest of your retirement portfolio? And given that there are so many varieties of annuities, what kind of annuity is the adviser actually suggesting?

Once you've mulled over these sort of questions, you'll be better able to evaluate your situation and decide how much of your husband's money, if any, should go into an annuity.

"If any" is an important distinction here. Although annuities are sold for a variety of reasons, I think the best use of an annuity is to provide guaranteed income for life. That's something no other investment can do.

But you note that you and your hubby already have good pensions plans. You'll also both qualify for Social Security benefits (which you can estimate by clicking here. Depending on how much retirement income you'll require and how much of it you can expect from those two sources, it's possible you may not need an annuity at all -- or that you may want to put even less than a third of your husband's 401(k) stash into one. Your pensions and Social Security may be able to provide all the income you need, or least enough for the foreseeable future.

How can you tell whether that will be the case?

Well, start by estimating how much income you must have to live the lifestyle you envision for retirement. Since your husband is retired and you're pretty close to calling it a career, you should be able to get a good sense of what your annual retirement expenses are likely to be. For help on that score, you can check out the interactive budget worksheet in Fidelity's Retirement Income Planner tool.

One of the things this worksheet does is allow you to separate essential living expenses (food, utilities, health and housing costs, etc.) from discretionary ones (entertainment, travel, gifts to the relatives and so on). That can be helpful for retirement income planning because it gives you a sense of how much wiggle room you have should you need to pare back your spending at some point in retirement.

In any case, once you have a good handle on your expenses, you can compare that figure to the assured income you'll be getting from your pensions and Social Security. There's no strict rule here, but for your own peace of mind you probably you want to have as much of your essential expenses as possible funded by assured income sources, starting with pensions and Social Security. If there's a gap -- i.e., your essential expenses will exceed your pension and Social Security payments -- an annuity can bridge some or all of it.

The type of annuity you would use to do that is known as an immediate annuity. Essentially, you hand over a lump sum to an insurer in return for guaranteed payments as long as you or your spouse is alive. The amount you receive will depend mostly on your age and the prevailing level of interest rates. To see what size payments you can get for a given sum in today's market, click here. If you want to be sure the income will keep flowing in even after one of you dies, you'll want a joint life, aka "joint-and-survivor," income option.

There's another type of annuity that's often sold these days as a retirement income vehicle -- a variable annuity with a guaranteed lifetime withdrawal benefit, or GLWB, rider. I'm not a big fan of this type of annuity in part because it often comes with high fees (although as I've noted before, in some circumstances this type of annuity could conceivably play a supporting role to an immediate annuity in a retirement portfolio).

You need to be especially careful about the guarantees that are often touted with a variable GLWB type of annuity. Often, in addition to the income guarantee, these annuities are sold on the basis of a guaranteed return, typically 5% to 7% annually. But the return guarantee almost always applies not to your account value, but the annuity's "income base," which is a hypothetical value on which income payments are based. If the annuity's account balance takes a dive and you want to cash out, you get the account value, not the value of the income base to which the guaranteed return has been applied.

Many annuity sales people do a thriving business in yet other types of annuities, most notably fixed deferred annuities, which are essentially like bank CDs, and equity indexed annuities, whose returns are pegged to a stock index. But I'm not a fan of these either, largely because they often carry surrender charges that can make them costly to exit. What's more, the formulas used to calculate equity indexed annuity returns can be mind numbingly complex, which makes them difficult to evaluate.

So the bottom line is that if after analyzing your income needs you find that your pensions and Social Security won't provide sufficient guaranteed income, you and your husband might consider an immediate annuity. Even then you might want to hold off buying until you leave work too. And if you do decide to go with an immediate annuity, think about spreading your purchase over several years so you don't "annuitize" all your dough when interest rates are low. For more advice on how to protect yourself when buying an annuity, click here.

If you decide you don't need an annuity -- or don't need one now -- then your best move is to roll over your hubby's 401(k) stash into an IRA and divvy up the balance in a mix of stock and bond funds that allows for some growth but won't get decimated if we see a repeat of 2008's carnage. You'll have to decide how conservative you want that stocks-bonds blend to be. But the more you want to favor protection over growth, the more you should tilt toward bond funds (short- to intermediate-term bond funds at that, to avoid getting hammered should interest rates rise.)

If you're not comfortable going through this sort of analysis on your own -- whether determining the income you need, evaluating an annuity or deciding on an appropriate mix of stock and bond funds -- then you may want to consult a financial planner, preferably one who isn't a shill for annuities (or who rejects them out of hand). You can hire a planner either on an hourly basis or for the longer term.

But your starting point in all this should be the questions I mentioned at the start of this column. Because if you're not clear on what type of annuities are being recommended, how they work and how they'll fit in with the rest of your portfolio, then you're making an important financial decision based on guesswork alone.

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