Sunday, August 14, 2011

Annuities: Insurance For Living Too Long

Given the choice, most people would rather live to be 100 than 70.  By living to 100, you get 30 extra years to spend with your grandchildren (and maybe even great-grandchildren), to travel, to play golf, and generally enjoy life.  However, there is a definite risk to living too long:  the risk that you run out of money before you die.

It used to be that most people relied upon Social Security and pensions to get them through retirement.  Both guaranteed you a certain level of income each month for as long as you live.  Social Security even increases its payments every year to account for the rising cost of living.  No matter if you lived to be 80, 90, or even 100, you were content in the knowledge that you got a check each month upon which you could rely.

However, we have entered a world where people can't rely upon pensions and Social Security.  In the private sector pensions have gone the way of the dodo.  Pensions are still available to those who work in education or government, but even these are chronically underfunded.  Meanwhile, Social Security is under the microscope as the country's debt continues to rise.  What we have now is a situation where most people are reliant upon defined contribution plans (i.e. 401(k)'s, IRA's).  These plans do not guarantee any sort of monthly check.  You are free to spend as much or as little as you want each month.  However, once the money is gone, it's gone!

Most calculators estimate how much money you'll need to accumulate by the time you retire assume that you will live to a particular age (usually 90 or 95).  However, what happens if you are "lucky" enough to outlive this assumption.  If that happens, you'll be in a situation where you will run out of money before you run out of life.  Fortunately, there is a way to "roll your own" monthly pension.  You buy an annuity.

An annuity is an insurance product, similar to life insurance.  However, whereas life insurance protects your family financially if you die prematurely, an annuity protects you if you live too long.  In a typical annuity transaction, you give the insurance company some amount of money.  In return, the insurance company promises to pay you X dollars each month as long as you are alive.  If you live to be 150, you will be getting a check from your insurance company every month like clockwork.  On the flipside, however, if you drop dead the next day, the insurance company keeps your money (some annuities have a minimum payout so that your heirs might get some of the money back).

Just like life insurance, you don't buy an annuity to make money.  You buy it to protect yourself against outliving your money.  In other words, don't think of an annuity as an investment

There are many different types of annuities.  The simplest is an immediate annuity.  This is where you trade some lump sum of cash for a monthly check which starts immediately (hence the name immediate annuity).  In its purest form, you stop getting checks immediately when you die.  However, this situation is unpalatable for many people.  It opens up the possibility that you hand over $1 million on Monday and you die on Tuesday.  If that happens, you've just lost $1 million for your heirs.  In order to mitigate this risk, many annuities come with a feature which guarantees a certain number of payments regardless of how short you live.  You might not get back your entire $1 million, but at least you don't lose everything.  Of course, this option reduces your monthly payments because now the insurance company cover the cost of providing this option.

Another option is a cost of living adjustment.  This option provides for a increase in the amount of your monthly annuity check each year.  This can be based upon the rate of inflation or upon some fixed rate of interest.  Again, this option might reduce your monthly payments at the outset of the annuity since the insurance company has to cover the cost of providing this option.

Another form of annuity is longevity insurance.  In this form of annuity, you hand over your money to the insurance company, and they start paying you a monthly check when you reach a certain age (usually age 85).  If you die before that age, you get nothing.  Because of this waiting period, the amount that you would receive every month if you reach your target age is higher.  However, the probability that you get nothing is higher than it would be with an immediate annuity.

A third form of annuity is called a deferred annuity.  This adds a savings plan to the typical immediate annuity.  During your working years, you deposit money into an account that is held by the insurance company.  The money that you deposit accumulates tax-deferred in the account until you retire.  Once you retire, the money that has accumulated is returned to you in the form of an immediate annuity.

During the accumulation phase of the annuity, the money grows tax-deferred, meaning that you don't pay taxes on any interest that you earn on this money.  How much interest accumulates depends on the type of deferred annuity you own.  Some deferred annuities pay a guaranteed minimum rate of interest.  Others allow you to decide how to invest the money.  These annuities (often called variable annuities) allow you to allocate your money into various investments (stocks, bonds, etc), and the interest you earn is based upon how well your investments do.  However, many still offer some sort of minimum guaranteed rate of interest.  However, these often come with additional fees to pay for this option.

Generally speaking, you should be careful when you buy a deferred annuity.  There are a lot of different moving parts to them which make them hard to compare:  surrender fees, guaranteed interest rates, commissions, investment options, etc.  If you are considering an annuity, it may be simpler to allow your money to accumulate in a 401(k) or IRA and then buy a immediate annuity when the time comes.  The only time you might want to consider a deferred annuity is if you have already maxed out your other tax-deferred investment options.

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