When you retire, your monthly income will plummet unless you have an unusually generous pension. But there is a way to replace income no matter how long you live.
An annuity can pay guaranteed monthly income for the rest of your life. But some prominent self-serving “experts” spread myths about annuities that discourage people from exploring what may be a good solution for them.
Deferred and immediate income annuities do the same things; it’ just a matter of timing. A deferred annuity, which pays out in the future, lets your money grow tax-deferred until you start taking payments. But if you didn’t buy one in advance of retirement, it won’t solve the need for immediate income.
An immediate annuity does just that because you’ll typically start receiving monthly payments within about a month of purchase. Besides providing income that replaces your salary or self-employment income, an income annuity insures against the risk of living longer than average.
It’s the only type of true longevity insurance. You transfer the risk to an insurance company in exchange for a premium.
Thanks to advances in medicine and more seniors staying active, many Americans are living to a great age. A healthy 65-year-old man has a 50 percent chance of living beyond age 85 and a 25 percent chance of living beyond 92. A healthy 65-year-old woman has a 50 percent chance of living beyond 88 and a 25 percent chance of living past 94.
Risk-pooling and guarantees are what make lifetime annuities so valuable. With lifetime annuities, the 50 percent of people who die earlier than average subsidize those who live longer. Since you don’t know which half you’ll be in, it makes sense to reduce your risk.
You can self-insure against longevity risk by investing in stocks, bonds, and savings. You’ll need to save 25 percent to 40 percent more than with an annuity because you won’t have the advantage of risk-pooling, according to a Wharton Financial Institutions Center study.
How much will you need to annuitize? First, try to determine how much monthly income you’ll need at a minimum in retirement. Then, subtract out Social Security and other pension benefits, if any.
How an immediate annuity works
You buy the annuity with a single payment. You can choose from different income payout periods, such as a certain number of years or for the remainder of your life.
The optional cash-refund feature guarantees that your premium payment will not be lost in the event of early death. Most people choose it.
With that option, if you die before your monthly income payments equal the full amount of your annuity purchase price, your beneficiary will receive the difference. For example, if you deposited $100,000 into the annuity and received $50,000 in monthly payments before dying, your beneficiary would receive the remaining $50,000.
Other annuity advantages include:
- The potential for higher returns. Annuities often pay higher rates than other guaranteed vehicles such as bonds, CDs, and money markets. As interest rates have gone up over the last few years, so too have income payments on new annuities.
- Lower taxes. The exclusion ratio refers to the percentage of the annuity's income that is considered a tax-free return of principal. Once you get your entire principal back, the payments will become fully taxable, but that won’t occur for a number of years.
- Protection from creditors. In many states, an immediate annuity is shielded from the claims of creditors.
- Guaranteed lifetime income. By choosing this payout option, you can receive income for the remainder of your life, even if you live to 110. You may also opt to add another income recipient such as your spouse, so he or she will continue to receive lifetime income after your death. This option lowers the payment somewhat because you are covering two lives.
Would an immediate annuity work for you?
Because it produces immediate income, it’s a good choice if you’re retired or about to retire. In contrast, deferred annuities make more sense for people who aren’t about to retire.
Because an immediate annuity converts a lump sum into an income stream, the funds you use for the annuity will no longer be available in case of an emergency. Make sure you still have enough liquid assets available for other needs.
Annuities are guaranteed by the issuing insurance company, so choose a strong insurer.
Annuity expert Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed and immediate-income annuities. He launched the AnnuityAdvantage website in 1999 to help people looking for their best options in principal-protected annuities.
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