Annuities

The nice thing about pensions is that you know what you are going to get and when you’ll get it. Anyone who has experienced the stock markets bouncing up and down, and then lived through the real estate roller coaster knows that economic certainty is about as easy to find as Nessie. With traditional pension plans going the way of the dodo, what certainty for retirement is there?

There’s Social Security. Hahahahahahahahaha. Okay, now that we’ve had our little laugh, let’s be serious for a moment. Social Security isn’t going to disappear. It may not be as generous in the future as it is now, but it will be there in some form when you retire. How can we be sure? Because no politician in Washington will let it die for fear of losing his or her job. Congress is one of the few places where you get paid well over 100K a year to talk all day without having to do anything. Very few members want to give up a job like that.

But is there any other certainty? One thing that the insurance industry is promoting is the idea of an annuity. There are about as many different types of annuities as there are types of cars, and we will focus today on the ones that supposedly provide certainty: the lump sum immediate fixed annuity and the lump sum immediate inflation-adjusted annuity.

The lump sum immediate fixed annuity is simple in concept. You pay an insurance company some money and the company agrees to pay you a fixed monthly payment for life. The time period of payments can also be limited, such as for ten or twenty years, but an annuity usually makes the most sense if you get the promise of payments for life. The amount of the monthly payment will vary depending on the amount you invest, interest rates, your age and gender, the fees and charges of the insurance company, and perhaps other factors.

There are also inflation adjusted annuities, where the amount you get will start off lower than it would for a fixed annuity. However, it will be increased in line with inflation, so over the long run, you may feel more secure. It may start out with payments that are 25% to 30% lower than fixed annuities, but depending on inflation could end up much higher.

One of the tradeoffs with these annuities is that you lose access to the principal you invest in them. In other words, if you spend $100K to buy an annuity and die the next day, your heirs are out of luck. They won’t inherit a penny of that 100K. (There are modified annuities that provide for somewhat of an inheritance, but it costs you in terms of reduced monthly payments and the inheritance feature will usually expire after a few years.)

Is it worthwhile to buy an annuity?

First, you need to have some real cash. Insurance companies like customers who can throw 100K, 200K or more at these things. If you’re going into retirement with a house, 50K or 75K in savings and Social Security, don’t bother with an annuity.

Second, if you have the money, don’t spend more than half of your financial assets on an annuity. You may have serious cash needs in retirement—assisted living facilities are not covered by Medicare or Medicaid. And other health care expenses may also not be insured. You can’t retrieve the cash in the annuity, so you’d better keep a good sized bundle on hand. Invest your remaining assets in a diversified portfolio with some stock market exposure, as a hedge against inflation.

Third, if you have Social Security and a pension, you probably don’t need an annuity. Between Social Security and the pension, much of your finances are already annuitized. Keep your financial assets for the major cash needs that may arise. Invest them in a diversified portfolio with some exposure to stocks to provide a hedge against inflation.

Fourth, think about whether an annuity might help you control your spending. If you’re likely to spend down your savings rather quickly, annuitizing part of them might help you make your money last through retirement. You could look to the annuity payment, plus Social Security, to cover your ordinary living expenses. An annuity may not be a great investment (usually, they’re not because the fees and charges are rather high). But if the steady payments from an annuity would give you a psychological boost and keep you from spending down the rest of your savings quickly, then it might be a good idea.

Remember that annuities are subject to the risk that the insurance company may fail, and be unable to pay its obligations. Research the creditworthiness of the insurance company before buying.

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