Value Added
Buy a Pension With an Immediate Annuity
Annuities have gotten a bad rap among investors -- and for good reason. But there’s one kind of annuity that can be a godsend.
By Steven Goldberg, Contributing Columnist, Kiplinger.com
November 17, 2009
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Hate annuities? Welcome to the club. For the overwhelming majority of investors, they make no sense. Seniors, especially, often fall for the security of a guaranteed floor on their annual returns without having any idea of how annuities’ outrageous fees rob them of potential profits.
But one kind of annuity works beautifully for many, if not most, retirees. Far too few people buy these annuities -- because salespeople can’t earn much selling them and because the personal-finance media have soured savvy investors on annuities.
I’m talking about immediate fixed annuities. When you buy an immediate fixed annuity (henceforth, I’ll call it an IFA), you buy yourself a pension (see Do-It-Yourself Pension). You give the insurance company a lump sum, and it sends you a check every month for a guaranteed amount for the rest of your life. When you die, the insurance company keeps anything that’s left of your premium. Think of an IFA as term life insurance in reverse -- the longer you live, the better you do.
The monthly payments are generous. For example, a 76-year-old man who came to me for advice was offered a 10.6% annual return on an IFA. In today’s low-interest-rate environment, that’s much better than he could do in all but the riskiest bonds. It’s also probably better than he could do if he put all his money into stocks. There is a catch: With an annuity you don’t get your money back.
Why such big payments? The insurance company pools premiums from thousands of annuities and invests them primarily in bonds. The company also makes educated guesses about how long annuity buyers will live. Then it makes monthly payments to policyholders each month based upon both expected longevity and expected investment returns.
IFAs usually make sense only for retirees. The older you are, the fewer years, on average, the insurance company will have to pay you benefits -- so the bigger your monthly checks.
For many people, age 65 is a good time to begin considering IFAs.
Think of an annuity as a place to put some of your bond money or cash. A typical retiree may hold 40% to 60% of his or her assets in bonds yielding 5% or less, with the rest in stocks. You could boost your income significantly by putting, say, two-thirds of the bond money into IFAs. A 65-year-old man can earn 7.4% annually on an annuity. A 70-year-old woman can earn 7.9% a year. And a 75-year-old Florida couple can earn 9.1%. (These rates apply to all states except about five, including California and Nevada, which tax premiums, meaning you receive a slightly lower monthly payout.)
Insurance companies usually make hefty profits on their products, and they certainly don’t give away IFAs. But it’s difficult to mark them up much because consumers can so easily compare one company’s IFA against another’s. They’re like term life insurance in their simplicity.
How to buy annuities
The best place to start your search is at ImmediateAnnuities.com (800-872-6684). Plug in the state you live in, your age and your gender, and the Web site instantly spits out quotes from numerous companies. You can often get a better deal through Vanguard (800-357-4720). If you or a relative has been in the military, also check out USAA (800-531-8722). Some credit unions also offer low-cost annuities.
But don’t jump in all at once. The higher bond yields are, the more you’ll collect from an IFA -- and I don’t have to tell you how low yields currently are. No one can accurately predict with any consistency when yields will change or by how much. So the smart approach is to invest relatively small amounts in an immediate annuity every couple of years or so.
Make sure, of course, to buy from a company that holds a top credit rating from A. M. Best. You don’t want the company you buy an annuity from to go bankrupt. That’s why it’s a good idea to spread your purchases among several different insurers.
Annuities don’t make sense for everyone. If you’re in poor health, you may not earn enough to compensate for your initial investment. Money you invest in an IFA is immediately gone -- you can’t get it back for any reason. You certainly can’t leave it to your heirs. That’s why annuities seldom make sense for all of an investor’s money.
Insurance companies offer a variety of options to suit your needs. You can buy an annuity that guarantees that your heirs will get a portion of your initial investment if you die within a certain time. You can also buy an annuity that boosts your payments in line with inflation. Obviously, an annuity with a cost-of-living adjustment will cost more than one without a COLA.
I’d generally steer clear of these embellishments. They complicate the annuity, making it harder to comparison shop. They also shrink your monthly payments. Inflation protection is a good idea in theory, but relatively few insurers offer it, so there isn’t much price competition.
There is one extra that is often worth having. You can buy an annuity that lasts as long as either you or your spouse lives.
The trick to making immediate fixed annuities really pay off is one all of us would like to accomplish: Live to a ripe -- and healthy -- old age.
Steven T. Goldberg is an investment adviser.
Reader Comments (10)
Posted by: Phil Strick at 11/17/2009 03:40:40 PM
May want to look at Nationwide's Income Annuity (an immediate annuity). Under certain circumstances you CAN get your money back. Since it is a variable, there is the possibility of income increases, but you CAN set an income floor - at a cost. Pretty unusual contract that is unique in the industry I believe.
Posted by: david gray at 11/17/2009 03:46:56 PM
sounds to good to be true and proably is,
Posted by: wkgrt at 11/18/2009 12:46:40 PM
This make no sense. Yes, I can get 10 percent, but I no longer have the cash I gave the insurance co. What if I suddenly need it? I would be better off just keeping my money in a safe investment at this age. I get a percentage and also keep my money. This way, you get a perecntage but give away your savings. You will be better off to collect less interest and keep your money. If you needmore, take it out of your savings. This is yet another insurance company gimmick.
Posted by: James Altschuler at 11/18/2009 02:11:47 PM
You are missing a huge point. A 65 year old male is not earning 7.4% annually. He is getting his own principal back and earning a much lower percent. For example, if he invested 100k and got 7400 for 20 years he got 148,000. 100k of his own money and 48k of earnings. I would have to run a IRR calculation, but I am guessing it is less than 2.25% per year. Pretty lousy for 20 years. I think I could find investments for my clients that can beat that any day of the week. Plus if they die early there beneficiaries will get what left over, unlike the IFA. You give a lot of great advice, but this time I do not agree with you. IFA earnings are misrepresented all over the place and most people do not understand what are buying. Just my 2 cents.
Posted by: Bob at 11/18/2009 03:37:53 PM
I recently went to an annuity seminar where they were trying to convince everyone that they would live to be an average of 92. Sounds like something we would all like to believe but not very likely. We all have at least one relative who lived well into their 90s but very few. They worked hard and weren't overweight like most of us nor did they grow up eating greasy fast food. Since I will likely be in declining health and no longer traveling much after about age 75, I see little logic in an annuity that will likely end up keeping most of my money. I'd rather leave what's left to my kids. If I do live to be 92 and run out of money. I will have broke even. If I live longer, I'll worry about it then.
Posted by: C. Morrison at 11/19/2009 12:15:49 PM
Yes, USAA has immediate fixed annuities. But they do not sell variable annuities. As a USAA member I was uncermonously dumped out of my variable annuity. It seems USAA does not want to deal with the risk. My advice is to stay clear of all USAA annuities and go with Vanguard, T. Rowe Price or Fidelity.
Posted by: bruce at 11/19/2009 02:03:27 PM
all of you including the author need to do more research. Annuities of any type are like tools in the tool box that need to be properly selected for the job. Couple of examples; some ia contracts can be established that leave a death benefit, others can be found that allow access to the principal and offer increasing income tied to some benchmark. As usual, absolutes are wrong. There are major problems with all financial tools if they are used incorrectly.
Posted by: michael whitten at 11/19/2009 02:10:00 PM
I am disappointed in my peers with their comments on immediate annuities. The author failed to mention the difference between non-qualified and qualified funds when purchasing an annuity. I'd recommend using non-qualified funds so the majority of your checks received are a return of principle and not interest. A return of principle for a 65 year old man with be around 65% for the first year, leaving only 35% of his (for sake of simplicity) $1,000 monthly check with $350 per month that could be taxed. It doesn't take much financial education to see the tax benefits of an immediate annuity from the return of principle standpoint. The other thing everyone fails to realize is that annuities are insurance, not stocks designed for capital gains for the purchaser. I would ask James and Wkgrt to show me any other product(especially from the goverment) that matches the security and after tax returns that an annuity does. I can't find one out there without a risk that far exceeds the risk of dying early. If a return of your lump sum is the ultimate disqualifier for purchasing an immediate annuity look into a term life insurance policy or investing part of your monthly annuity check back into the market. It saddens me when people immediately label annuities and insurance companies as some kind of evil threat to ones financial well-being. These products are well regulated and their history can be traced back hundreds of years as solid income generating products. One counter on the post by James below on the "7.4% annuall"y comment. If you invest $100k into an account returning 6% per year and withdrawal $7,400 from it each year, you would You would be able to make 24 Annual withdrawals, with a remaining balance of $6,296.08. With a total balance of 183,896.07. However, the difference is you are reliant upon a balance that never stays above the original principle deposit once the first deposit is taken nor are protected by a guarantee enforced up to a maximum of around $300,000 per state insurance commission. I will not argue that you get more money and flexibility with investing into an account with 6% return but when you're 85 the last thing you'll want to do is see how the S&P 500 performed this month. Anywho, I'm not against investing and executing the 6% example I talked about, but to turn a blind eye on immediate annuities which have been around much longer than social security is just ignorance. The author clearly stated not to invest all your funds into them, but laddering or funding your minimum monthly income requirements is a great burden to have lifted off your shoulders when its time to punch the clock for the final time. Just my thoughts, security before anything else in my humble opinion. Thanks, -mike.
Posted by: Nomen at 11/19/2009 03:10:37 PM
Bob's right. Most of us will not live long enough to really benefit from annuities. Just for your own information, try averaging the ages for the past month in your local newspaper obituaries. It will almost always come up 70 something, not mid 80s, and certainly not 92. Also remember HALF of us will pass sometime before the average. Annuity salesman always like to use the most optimistic data they can find and statistics can be very deceiving. By the way Mr. Goldberg, your new photo is much better.
Posted by: Patsy Livingston at 11/20/2009 11:17:58 AM
Annuities are nothing but a contract with an insurance company. If they go bust that contract stands in line for its money just like the maintenance contract, etc. You forgot to mention that part. For that reason alone, I will not purchase an annuity. Correction, I have one annuity...my social security check.