Risking My Life

Jonathan Clements

THREE WEEKS AGO, I wrote about my plan for generating retirement income, including my intention to make a series of immediate fixed annuity purchases. Immediate annuities are a profoundly unpopular product, so I was surprised when the article generated a slew of questions from readers.

Perhaps that interest reflects today’s miserably low bond yields, which have left immediate annuities as one of the few ways to generate a safe and sizable income stream. Intrigued? Here are answers to six of the questions I received:

1. Why the heck would you buy an annuity? Many folks hear the word “annuity” and instinctively recoil in horror. But if you’ve researched the topic, you’ll know there’s a huge difference between a plain-vanilla immediate fixed annuity and, say, a tax-deferred variable annuity or an equity-indexed annuity.

Ponder this: Finance professors are often big fans of immediate fixed annuities, because they leverage a key economic concept—risk pooling—to deliver a simple, relatively low-cost solution to retirement’s biggest problem, which is the danger that you’ll outlive your money. Meanwhile, insurance agents are not big fans of immediate fixed annuities. Instead, they’d much rather sell you a variable or equity-indexed annuity, because these products pay them far larger commissions. In fact, immediate fixed annuities typically pay the salesperson just 1% to 3% of the money invested.

In return for that money, you get an income stream you can’t outlive—and which could make your retirement far less financially stressful. Let’s say you’re a 65-year-old man. If you stashed $100,000 in an immediate fixed annuity, you might get $5,460 every year for life, according to a quote earlier this week from Saturday Insurance, the website run by Dennis Ho, a frequent HumbleDollar contributor. A 65-year-old woman would receive some 6% less, reflecting her longer life expectancy. Meanwhile, if you put that money in a total bond market index fund, you were recently able to get a 1.16% yield, or $1,160 a year for every $100,000 invested.

What would happen if you tried to live off the bond fund to the tune of $5,460 a year, thus matching the income from the immediate annuity? Not long after you turned age 85, the fund would be depleted, while the annuity would keep on paying. On the other hand, if you died before then, the bond fund would be the better bet, because the fund would still be worth something, while buying the annuity means kissing your $100,000 goodbye.

So is the annuity a good deal? Think of it this way: On average, a typical 65-year-old man can expect to live until age 84, while a healthy 65-year-old might live four years longer. That gives the annuity an edge, but not an overwhelming one—until you consider one additional advantage: You know the annuity will keep paying, no matter how long you live. Meanwhile, spending down the bond fund will be a nail-biting exercise—and there’s a risk you’ll either deplete your fund holdings or, more likely, slash your spending out of fear you’ll end up destitute.

2. What about inflation? The best inflation-indexed annuity available is delayed Social Security benefits. Indeed, for those looking for a healthy stream of guaranteed lifetime income, postponing Social Security should be their top priority, with immediate annuities viewed as a way to generate additional lifetime income.

Today, there’s no true inflation-indexed immediate annuity available. You can, however, purchase annuities where the annual payments rise at, say, 2% a year. For our hypothetical 65-year-old man, a $100,000 immediate annuity with a 2% annual income increase would kick off $4,320 in the first year, according to a recent quote. In terms of the total dollars paid out, this rising income annuity would catch up with a fixed $5,460-a-year annuity at age 88 and pull away thereafter.

What about other optional features? You can get guaranteed payments for, say, 10 or 20 years or, alternatively, the promise of a “refund” for your heirs if the annuity’s total income during your lifetime is less than your original investment. Problem is, these features can mean significantly reduced income, so I’d be inclined to skip them.

3. At what age should you buy? The older you are when you buy an immediate annuity, the more income you’ll get, thanks to your shorter life expectancy. Still, my plan is to make a series of immediate annuity purchases starting at age 60.

Why that approach? I see three advantages. First, by buying early in retirement, I have greater confidence I’ll get a fair amount of income back from my annuity purchases.

Second, by making multiple purchases, I eliminate the risk that I’ll make a big onetime annuity investment and then keel over a few months later. Instead, if I set out to buy a new immediate annuity every few years from age 60 to 70, I leave myself the option to stop the periodic purchases if my health deteriorates. A deterioration in my health would also prompt me to claim Social Security right away.

Third, with my multiple purchases, I can buy from a variety of insurance companies, thus reducing the fallout should any one insurer get into financial trouble. An added bonus: If interest rates head higher from today’s anemic level, that’ll give a boost to the income paid by the annuities I buy later on.

How much will I pony up for each annuity? I haven’t decided. But ideally, buyers should invest $100,000 or more, because they’ll have a larger pool of insurers competing for their business, says Saturday Insurance’s Dennis Ho. Still, it’s possible to pursue a multiple annuity strategy with far less money. He notes that there are insurers that sell annuities for as little as $5,000 or $10,000.

4. What insurance company rating should you look for? Ho advises sticking with insurers rated A+ or higher for financial strength by Standard & Poor’s, or with comparable ratings from A.M. Best, Fitch Ratings or Moody’s. “That’ll ensure you have a pretty high-quality company,” he says. “But also make sure it’s a big-name company. Make sure it’s been around 100 years,” so the insurer has a track record of navigating all kinds of economic environments.

Keep in mind that an insurance company’s financial strength isn’t the only thing standing between you and a worthless annuity. While little publicized, every state has a guaranty association that provides a safety net, should an insurer get in financial trouble. The amount of protection varies by state.

5. Which financial account should you use? You could potentially purchase an immediate annuity with money from a taxable account, a traditional tax-deferred retirement account or a tax-free Roth account. A taxable account purchase would give you annuity income that’s partly taxable each year and a Roth purchase would result in tax-free income. Meanwhile, an annuity purchased using your traditional retirement account would buy an income stream that’s 100% taxable.

Despite that, my plan is to purchase my immediate annuities using my traditional retirement account. Thanks to required minimum distributions, I’ll be compelled to spend down that account anyway. Meanwhile, I’d like to bequeath both my Roth and my taxable account to my two kids.

6. What about deferred income annuities instead? I’m buying immediate fixed annuities because I want regular income throughout my retirement, partly to cover living expenses and partly because it’ll free me up to invest more of my portfolio in stocks.

But Saturday Insurance’s Ho puts in a pitch for deferred income annuities, otherwise known as longevity insurance. This involves buying an annuity today that will start paying income later. There’s even a special tax provision that makes it advantageous to use a retirement account to purchase longevity insurance.

If our 65-year-old male opted for a deferred income annuity that begins paying at age 75, the income he’d receive in 10 years would be almost twice what he’d get today. “If you’re trying to maximize protection for your later years, a deferred annuity offers decent value,” Ho argues.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Take the Low RoadJust Another Day and Almost Zero.

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