Guaranteed income for life — at a price

Anxiety about running out of money before running out of life likely keeps some retirees awake at night. In Bankrate’s recent poll, roughly four out of 10 (37 percent) retirees worry about outliving their money. Women fret more than men by a margin of 44 percent to 28 percent.

While modest habits and frugal living can go a long way toward tempering those night sweats, insurance products called “annuities” allow you to hedge the risk that you might inadvertently live too long.

An annuity is a contract between you and an insurance company stating that you will pay the company a set amount, and then it will turn around and pay you back with interest for a set number of years or for life.

The amount you receive depends on a few different factors — for instance, the type of annuity you buy. Your payout can be based on a fixed amount or it can vary, depending on the performance of underlying investments.

Annuities have a bad reputation for imposing restrictions and piling fees on top of fees, and they have other drawbacks. But they can be a useful tool in the right circumstances.

Whether that tool belongs in your investment toolbox depends on your personal situation.

Lowdown on annuities
4 types of annuities Bells and whistles
Deferred. Guaranteed minimum income benefit.
Immediate. Guaranteed lifetime withdrawal benefit.
Fixed. Guaranteed minimum withdrawal benefit.
Variable. Death benefit.
Other guarantees.

Deferred annuities

Deferred annuities have two phases: accumulation, where you earn interest on your investment, followed by the distribution phase, when the account is annuitized. The investment gains are tax-deferred until you begin taking withdrawals.

You can purchase a deferred annuity with a single premium or on an installment basis.

“The accumulation period is from the day you open the account to the day you terminate the contract or annuitize. You basically call up the insurance company and say, ‘OK I want an income stream. I’m willing on this day to exchange the balance of the account and give it to you (in exchange for regular payments),'” says Mark LaSpisa, Certified Financial Planner with Vermillion Financial Advisors in South Barrington, Ill.

Who they’re good for: Investors who have maxed out their qualified retirement plan contributions, such as an employer-sponsored plan and IRA, and would like their money to grow tax-deferred. They’re also good for those facing imminent retirement, but who don’t want to get an annuity until sometime in the distant future.

“You’re not worried about dying tomorrow. What you’re worried about is living past 80 and then you’ll have a problem. You say to the insurance company, ‘I want to buy a payout annuity, but I don’t want the payments until I reach 80,'” says Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis.

“Now instead of having to put up $500,000, you only have to put up $50,000 or some small number because if you don’t live to 80, the insurance company will never pay you a penny,” he says. 

In some states, money in annuities is judgment-proof, so deferred annuities can be a good vehicle for people in professions prone to lawsuits, such as doctors, lawyers and Enron executives. Ken Lay stashed millions in annuities shortly before the scandal erupted that left thousands of Enron employees completely broke.

Immediate annuities

Immediate annuities have no accumulation period. Buyers plunk down their payments and go straight to the distribution phase.

“An immediate annuity guarantees you a set amount of income for life — or for your and your spouse’s life. It is similar to a pension-type income stream,” says Craig Hemke, president and founder of Buyapension.com.

Who they’re good for: risk-averse retirees or those facing retirement who need an immediate source of income for a set number of years or until they die.

Fixed annuities

A fixed annuity earns a fixed rate during the accumulation stage. Generally, the interest rate is agreed upon for the first year and then is reset in subsequent years based on market conditions. But investors can find annuities with a set interest rate that lasts for a number of years. During the distribution period, fixed annuities are regular fixed payments that don’t change in amount.

“Fixed annuities are pure insurance contracts. You buy them from the insurance company and they basically make you a payment based upon their expected returns for that period and the mortality credits,” says Swedroe.

Mortality credits are the reallocation of monies from those who die to those who survive. They make annuities attractive for older investors. Read more about mortality credits in the Bankrate feature “The pros and cons of annuities.”

Variable annuities

The payout from a variable annuity will be based on its underlying investments, called subaccounts. These accounts fluctuate in value.

“Variable annuities are really a lot like tax-deferred mutual funds — you put money in, you select the funds and you hope over time that it grows,” says Hemke.

In recent years, insurance companies have thrown many sweeteners into the pot, in the form of guarantees called living benefits, to make annuities more appealing to consumers.

“You could buy a mutual fund instead and if it goes up, great. If it goes down, uh-oh,” says Hemke.

If you buy a variable annuity with a guarantee, your investments still have the potential for growth, but if they lose money, your payout level will never dip below a certain point, Hemke says.

In the recent market downturn, variable annuity investors enjoyed protection from losses and some even made money in 2008, when the S&P 500 lost nearly 39 percent, according to The Wall Street Journal. In response, insurers had to build up their reserves, and some have scaled back their guaranteed offerings.

Bells and whistles

While guarantees hedge the downsides of variable annuities — such as losing money and forgoing a legacy for heirs — they add to the ongoing expense of the product. Warning: They are also incredibly complex and restrictive. Below are simplified explanations of some available guarantees. Be sure to dig up all the details (read the prospectus) before parting with your money.

Guaranteed minimum income benefit

As described above, this guarantees a certain level of payments after annuitizing, even if your account experiences investment losses. To get this guarantee, you generally cannot access your money during the accumulation period without possibly jeopardizing the guarantee. Income payments are based on the greater of either the actual realized value or your principal plus an interest rate.

Guaranteed lifetime withdrawal benefit

These riders allow investors some flexibility. For instance, you can withdraw a percentage of your funds (generally between 3 percent and 7 percent, depending on your age) without annuitizing, and you can increase the amounts withdrawn if the investments do well — provided certain conditions are met.

Simply put, they “guarantee you an income without annuitizing,” says Douglas Neal, CFP at Neal Financial Group in Houston.

“It can go by different names, but the gist is that the insurance company says if you don’t take out more than 5 percent a year (of the account value on the date the withdrawals begin), then we guarantee you that amount of money every year that you live, even if you use up all your money in the annuity,” he says.

Guaranteed minimum withdrawal benefit

This is a similar guarantee to lifetime withdrawal benefits, except that the payout lasts only as long as the original principal amount. It protects your investment even if the market erodes its value, and will allow you to withdraw a certain percentage every year until you’ve recovered the initial investment.

Death benefit

One of the risks of buying an annuity is that you will die before you begin taking payments or before your investing principal has been exhausted. A death benefit rider ensures that if your life ends before the annuity payments begin, your heirs can still cash in. On a variable annuity, where the value of the account can rise and fall with the market, a guaranteed death benefit enables beneficiaries to inherit the full investment amount even if the market diminished the value of the account.

Other guarantees

Though the most common way of buying an immediate annuity is called life only, where the buyer is basically making a bet against the insurance company that he or she will live longer than the company expects, you can get some guarantees and protections for your beneficiaries. Of course, these guarantees come with a price in the form of lower payouts.

For example, buyers can attach a period certain guarantee, where the insurance company guarantees you at least a minimum number of years of payments.

“If you were to buy life-only with 10-year period certain, that means they’re at least going to guarantee 10 years’ worth of income to somebody,” says Hemke.

“So if you live for 40 years, the income will go for 40 years. But if you live for four years, the contract guaranteed a minimum of 10. So whoever you named as beneficiary is going to get the other six,” says Hemke.

Cash refund is another option that is becoming even more popular.

“That is a refund or return of your principal. Say you put $100,000 into an immediate annuity, and that is going to pay you $10,000 a year for life,” says Hemke.

“So a bus comes along and flattens you after you have gotten out $20,000 — there is an $80,000 difference between what you put in and what you got out. Whoever you named as beneficiary is going to get the $80,000 back,” he says.

Financial planners are split on annuities. Though most concede that there is a time and place for all types, the most commonly recommended is an annuity with a fixed payout.

They can provide a little bit of insurance against landing in the poorhouse in your old age.

But before purchasing an annuity, read about some of their pros and cons.

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