2 ways to get guaranteed retirement income

Secrets of a dream retirement
Secrets of a dream retirement

My wife and I have about $1 million in stock and bond funds in 401(k)s, IRAs and other retirement accounts, but are wondering whether to buy an annuity when we retire within the next few years. Do you think that's a good idea?--Scott C.

Ask advisers this question and the answer may depend on how the adviser makes his living. If he or she sells annuities, you'll probably hear how wonderful annuities are and why you should have one. If, on the other hand, the adviser charges a fee to invest retirees' savings for retirement income, you'll likely get an earful about annuities' shortcomings and reasons why keeping your savings in stocks, bonds and other investments is the better way to go.

The problem is that these answers may reflect what's best for the adviser rather than what's right for you.

So, let's try a different approach. Let's weigh the pros and cons of annuities, and then consider why you might want to put a portion of your retirement savings into one or more annuities, or why you might decide to exclude them from your investing strategy altogether.

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The single biggest advantage annuities have over other investments is that they can pay income that won't run out no matter how long you live. They're also able to generate a higher level of sustainable income than you could generate investing on your own taking comparable risk. How are they able to do this? Simple.

When insurers create annuities, they pool the money of thousands of investors. Insurers are then able to base payments not just on a projected investment return, but on their actuaries' estimates of how long the annuity owners will live. Knowing that some annuity holders will die sooner than others, insurers are able to boost annuity payouts beyond what investment returns alone can support by in effect transferring money from those who die early to those who die late. These payment enhancements are known as "mortality credits."

Of course, annuities also have drawbacks. If you want to maximize the size of the annuity's payment, you usually lose all or most access to the money you invest an annuity. So it won't be available for emergencies and such, or as a legacy to your heirs. And if you die earlier rather than later, then the total value of the payments you receive may not be much more (or could even be less) than the amount you invested. So an annuity wouldn't make much sense if you've got serious health issues that might result in premature death.

There's also the chance that the insurer might not be able to fund those payments, although that risk is relatively small since insurance regulators require insurers to set aside reserves to meet obligations. You can further protect yourself by sticking to annuities issued by insurers that get high financial strength ratings from companies like A.M. Best and Standard & Poor's, by spreading your money among two or more highly rated insurers and by limiting the amount you invest with any single insurance company to the maximum coverage offered by the state insurance guaranty association in your state. By investing smaller amounts over the course of a few years rather a large sum than all at once, you can also avoid putting all your money into an annuity when interest rates and annuity payouts are at or near a low point.

Given an annuity's pluses and minuses, why might you want to consider investing a portion of your retirement savings in one?

One reason would be to receive more guaranteed income than you'll collect from Social Security and pensions alone. Many retirees enjoy the feeling of security that comes from covering all or most of their essential retirement living expenses with income they can count even if the market tanks. If Social Security and pensions already cover your basic expenses -- or if your nest egg is so large your chances of depleting it early are very small -- then you may not need or want more assured income. But if that's not the case, you might want to invest a portion of your savings in an immediate annuity.

A 65-old-man who invests $100,000 of his savings in an immediate annuity today would receive guaranteed payments of about $545 a month for life, a 65-year-old woman would get about $510 a month and a 65-year-old couple (man and woman) would receive $450 a month, a payment that would continue as long as either one was alive. Since it may be hard to gauge your exact income needs early in retirement, I think it makes sense to go cautiously -- that is, invest a small amount in an annuity (if any) initially, then re-evaluate and buy more guaranteed income later if you need it.

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But there's another type of annuity you might want to consider that offers a slightly different take on guaranteed income: a deferred income annuity, aka a longevity annuity. This type of annuity acts more like life insurance, except instead of paying off when you die, it starts making payments if you're still alive late in retirement (which is likely given today's long life spans).

Let's say you're 65 and are okay with funding your retirement income from savings invested in a portfolio of stocks and bonds for now. But you would also like to have some assurance that, should you deplete your savings sooner than you expect, you won't have to rely on Social Security alone.

In that case, you can buy a deferred annuity at age 65 with a payout that doesn't kick in until you're older -- say, 75, 80, even 85. Because you won't collect those payments for many years down the road, the amount you have to put into the deferred income annuity is much smaller than what you must invest to receive the same monthly payment from an immediate annuity. For example, a 65-year-old man would have to invest roughly $12,500 in a longevity annuity today to receive $545 a month starting at age 85, or the same payment he would have to fork over $100,000 to get from an immediate annuity. (Keep in mind that the longevity annuity's payments are in future dollars, which will buy less than the same dollar amount today.) To get quotes for different amounts, ages and starting dates, check out an annuity calculator.

The idea is that by opting for a longevity annuity rather than immediate annuity, you get to hold onto more of your assets now, but still have those assured payments coming in down the road. The downside: The version of a longevity annuity that offers the highest monthly payment provides no payments after your death. So it's possible you could collect very little, or even nothing if you die before payments start. There is a "return of premium" version of longevity annuities that refunds to your beneficiary any portion of your original investment you hadn't collected in payments before you died. But the payment is much lower -- $370 a month vs. $545 for a 65-year-old man investing $12,500 today for a payment that starts in 20 years.

Until recently, longevity annuities weren't a very practical choice if you wanted to buy one with money from a 401(k) or IRA, since federal regs generally demand you begin making required minimum distributions at age 70 1/2. But under new rules, you can now buy a longevity annuity within a qualified account such as a 401(k) or IRA without having to worry about required draws, as long as you invest no more than the lesser of $125,000 or 25% of your account balance, payments start no later than age 85 and the annuity is designated a qualified longevity annuity contract (or QLAC), as they're called in annuity circles.

Bottom line: an annuity may or may not have a legitimate role to play in your retirement income strategy. But your decision should hinge on what's in your best interest, not some adviser's.

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