Choosing the right immediate annuity

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An annuity is a complex purchase, even when you’ve chosen the simplest kind — an immediate annuity, where you give the insurance company a flat fee. The insurer keeps about 2 percent and what’s left is invested. You get monthly payouts over the course of your lifetime.

With an immediate annuity, you bet that you’ll live a long time and get back everything you put in, plus interest and more. The insurer bets that you’ll die at about the time that its longevity tables say you will — or before — giving them a profit and more money to put in the pot to pay out to other annuity buyers. If you live to be 100, you win. If you die in a couple of years after buying the annuity, the insurance company wins big.

Olivia Mitchell, department chair and professor in the Department of Insurance and Risk Management at the Wharton School of the University of Pennsylvania, has calculated what she calls “the money’s worth ratio” — the ratio of the expected cash flow of an annuity divided by the premium. Typically, a plain

“That is fantastic — but you have to look at it as insurance and not an investment,” Mitchell says.

This basic truth is what has made annuities a tough sell over the years. People hate the idea that they are playing a retirement craps game — putting a huge bet on the outcome of the roll of the dice. To mitigate this objection, insurers have devised modifications to basic annuities known as riders. These change the details of the bet, but most of the time, don’t improve your odds.

The National Association of Insurance Commissioners has written volumes on annuities. Last year, it created model “suitability” legislation that requires insurers to analyze whether the annuity it is selling a customer is suitable for that person’s situation. So far, 37 states have adopted this model legislation, which is supposed to protect you from being sold an annuity that doesn’t meet your needs.

Here are some of the most common riders on immediate annuities and some reasons why you may or may not decide to choose them. In any case, remember that each rider comes with a fee and even if it appears to be only a small number, if you’re charged more than once or you opt for several riders, the fees can add up.

Life annuity with period certain. If you live longer than the period certain, you’ll continue to receive payments until you die. If you die during the period certain, your beneficiary gets regular payments for the rest of the period you have selected, usually five, 10 or 15 years. Choosing a period certain lowers the amount of the payment you and potentially your beneficiary receive, but it reassures people who are worried about losing all of their money that at least some of it will go to their heirs. James Walsh, author of “You Can’t Cheat an Honest Man,” suggests that you make sure there isn’t a significant fee payable when you die and the beneficiary begins receiving payments.

Joint and survivor life annuity. The insurer pays income as long as either the insured or the beneficiary lives. Spouses generally buy annuities this way. The amount received will be less than a life annuity without this rider, and some people find buying a life insurance policy to cover the younger person more economical. You also can decrease the amount of the payments after the first death or limit the length of time during which payments continue for the second person. Either of these changes will increase the payout. The Urban Institute studied why spouses choose single rather than joint-life annuities and found that only 7 percent of men and 3 percent of women prefer single-life annuities in the absence of some compelling reason like imminent death of a spouse or a pending divorce.

Inflation protection. This starts the payout at a lower level, but increases it annually, usually by the government-calculated inflation rate. Inflation protection, Mitchell says, reduces the “money’s worth ratio” by about 5 cents on the dollar. Mitchell thinks that given our country’s current economic situation, inflation protection makes sense — “I’m an inflation hawk,” she says. Of course, if she’s wrong and inflation stays low, this could be a bad bet.

Longevity insurance. Generally, an insurer must begin paying a life annuity within 12 months of its purchase, but longevity insurance delays payment. You purchase the insurance with a single payment, and the date payments begin is deferred often for 20 years or longer. In the meantime, the insurer has the use of your money. If you die before collecting, you lose it. “(Longevity insurance) can be smart retirement planning,” says Mitchell, and these kinds of policies are a good bet for people who believe they will live a long time, based on longevity of family members.

Long-term care insurance. Some immediate annuities allow you to use some of the money you’ve put in an immediate annuity to pay for long-term care if you meet certain criteria. Walsh says this is the one rider that might be worth buying, “particularly if you aren’t inclined to buy long-term care insurance otherwise.”