Should I trust income annuities?

@Money August 4, 2011: 8:49 PM ET

NEW YORK (Money) -- I know that immediate income annuities pay a monthly check for life in exchange for a lump sum upfront. But their payments are based on the claims-paying ability of the insurance company behind the annuity. How can I be sure the insurer will make good on its guarantee and that I can count on the annuity's income well into the future, when I'll be most vulnerable? -- Gary H.

Whenever an investment comes with a guarantee -- whether it's an annuity, a mutual fund or, given the debt limit tussle we've just been through, even a U.S. Treasury security -- you need to know two things: what exactly is being guaranteed, and what stands behind that guarantee.

In the case of an immediate annuity, what's being guaranteed is an income stream, usually a monthly payment for life. There are lots of variations, however. For example, you can get income for the rest of your life or for as long as either you or your spouse remains alive (the joint-and-survivor income option).

You can also stipulate that you wish to receive income for life, but that a minimum number of payments are made. The "life with 10 years certain" option, for example, assures that the annuity makes payments for 10 years or as long as you live, whichever is longer.

Should I move my 401(k) stash into cash?

If you die two years after buying the annuity, your beneficiary would receive payments another eight years. To see how payments vary under these different options, click here.

It's also possible to get immediate annuities with cost-of-living adjustments that tie increases to the Consumer Price Index or boost them by a set percentage, say, 3% or 5% a year.

As for what stands behind an immediate annuity's guarantee, there is, as you noted, the claims-paying ability of the insurer. That depends on, among other things, the reserves the insurer has set aside for annuities, life insurance policies and other obligations, as well as the insurer's capital, or "surplus" as it's called in insurance circles.

Since most individual investors don't have the time, expertise or inclination to pore over insurers' financial statements, they rely on the ratings of firms such as A.M. Best and Standard & Poor's.

But there's another backstop: state guaranty associations. These organizations step in should an insurer find itself unable to meet its obligations. The safety net these associations provide can differ from state to state and also vary depending on what type of policy you own (annuity, whole life, etc.).

Are you on track for retirement?

So back to your question: How can you be sure an annuity's income will be there when you need it? Well, you can never be absolutely 100% sure. No investment (U.S. Treasury bills included) is totally without risk. But you can take precautions to bring that risk down to a manageable or reasonable level.

To do that, I recommend you do the following four things:

First, stick to insurers that are highly rated (generally, I'd say A or better) from major ratings firms. Yes, I know these ratings are far from infallible, witness the mortgage securities that collapsed contributing to the financial crisis. But would it make sense to ignore the ratings, or do business with an insurer that these firms consider weak? I don't think so.

Retiring in 10 years: Should I invest in annuities?

Second, diversify. Just as it makes sense to spread your money among a variety of stocks and bonds to mitigate the risk of a company imploding, it's also prudent to spread whatever money you're planning to put into an immediate annuity among the offerings of two or three highly-rated insurers. That way, all of your income isn't riding on the fortunes of one company.

Third, limit the amount you invest with any single insurer to the maximum coverage offered by the guaranty association in your state. That limit is typically $100,000 or more for annuities, but you can find the max for your state by clicking here.

Finally, don't put all of your retirement savings in an annuity, immediate or otherwise.

Just as you don't want your retirement security riding on the fortunes of a single insurance company, you also don't want it tied solely to one type of investment. Even aside from safety concerns, there are other valid reasons (liquidity and growth potential, to name two) you want to have a retirement income strategy that combines several different types of assets and investments. (For more on how to create such a strategy click here.)

So before you buy an annuity or any other investment because you like the idea of a guarantee, make sure you understand what's being guaranteed and who's doing the guaranteeing. And be sure to take the precautions I listed above.  To top of page

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