Oft maligned for high fees and low returns, annuities have long been viewed as an option reserved for the stodgiest of investors. Today, however, annuities are making a comeback as a savvy retirement planning vehicle.
What’s changed? People are realizing they could live a very long time.
With one in eight 65-year-old men and one in five 65-year-old women now living to 95, baby boomers have good reason to worry that they might last longer than their money. Then, too, the ups and downs of financial markets in recent years have made clear the damage that a few bad years can do to a retirement portfolio.
“People are looking for an income stream that they can’t outlive,” says Dana Levit, a financial planner with Paragon Financial Advisors in Newton. When properly used as part of a retirement portfolio, she says, annuities can serve that function well.
Annuities are financial products typically purchased with a lump sum and structured to provide regular income for a guaranteed period — often for life.
With traditional pensions becoming increasingly rare and many retirees facing diminished standards of living, the Obama administration proposed regulations designed to make certain annuities more attractive.
Annuities, however, can be a hard sell. In exchange for that guaranteed stream of income, buyers give up control of that money and forfeit the ability to leave those assets to their heirs. Then, too, there are lots of different kinds of annuities, with payout amounts, fees, and guarantees varying from product to product.
For retirement income planning purposes, the annuity product of choice is a low-cost single-premium income annuity guaranteed for life, says Manish Malhotra, founder of Income Discovery, an online software program that helps financial advisers build retirement income plans for clients.
Used strategically, it can fill the gap between income provided by sources such as Social Security and the funds needed to support a comfortable lifestyle. Often it can provide a higher payout than that available with other retirement income strategies. Moreover, any money or other assets remaining after an annuity is purchased can be invested for growth and eventually passed on to heirs.
“By planning smarter, you not only have more income, you can also leave more for your kids,” Malhotra says.
Take a 65-year-old couple whose annual lifestyle costs about $100,000. If they get $50,000 a year from Social Security and $25,000 from pensions, they would still need an additional $25,000 to make ends meet.
How do they make up the difference? A popular approach is to withdraw 4 percent a year from their nest-egg portfolio. That comes to just $4,000 a year for every $100,000 in assets. Under this scenario, the couple would need a $625,000 portfolio to come up with the needed $25,000 each year.
But that $25,000 isn’t guaranteed, since the amount will vary depending on market performance. And if markets do badly, the money could run out.
An annuity, however, can beat that 4 percent withdrawal. Based on recent quotes from Income Solutions, a Web-based annuity-purchase system, a 65-year-old couple can buy a $100,000 single-premium immediate life annuity that will pay a guaranteed $5,630 — or 5.63 percent — every year as long as either one is alive. That means that they would need $445,000 to generate the needed $25,000 each year.
For annuities based on a single life rather than joint life expectancy, the payout is even higher. That same $100,000 annuity, for example, would net a 65-year-old man $6,720 a year.
How can that be? The annuity payment gets a boost from what’s called “mortality gains,” meaning that the calculations assume a certain number of people in the annuity pool will die early, increasing the money available for payouts to others. In other words, explains Robert Ryan, a fee-only financial adviser with Resolute Financial in Wakefield, “The ones who die early pay for the ones who live longer.”
This, of course, is exactly what makes people so nervous about annuities, says Ryan.
While it’s great financially to cash in on someone else’s premature demise, there’s always the chance that you could be the one dying early. For that 65-year-old couple, one of the two would need to live another 17.8 years to get their initial investment back.
You can buy protection against an early death if you opt for an annuity that guarantees payments for a set period of, say, 10 years. That means your heirs would continue to collect for eight years if you die after two. This guarantee would decrease annual income. The amount: between $123 and $242 a year, according to several current Income Solutions quotes for a 65-year-old man
Other options include inflation-adjusted annuities, which will reduce the initial monthly payout but guarantee it will rise with inflation, or annuities that guarantee a 2 percent increase in income each year.
A trusted financial adviser can be useful, since advisers have access to sophisticated retirement income planning software and annuity purchasing services. Those who take a do-it-yourself approach should look for simple, low-cost contracts designed to address a specific income need.
Keep in mind that annuities should typically only be part of a nest-egg portfolio. Kelli Hueler of Income Solutions — used by mutual fund giant Vanguard, large employers, and financial advisers — says buyers typically allocate no more than 20 to 25 percent of assets to annuities
Who should buy an annuity? That depends. The bigger the gap between retirement income and lifestyle expenses, the less risk a retiree can afford, says fee-only financial adviser Rick Miller of Sensible Financial Planning in Waltham, noting that an annuity can be useful here in reducing both longevity and market risks. People with a bigger financial cushion can also benefit, particularly if longevity runs in the family, he says.
Most important, people should take the time to understand both their odds of living a long time and the potential impact of financial market swings.
“After all, some 80 percent of drivers will self assess as being above average,” says Miller. “People are similarly optimistic about their ability to not outlive their money.”