Using Annuities to Cover Basic Living Expenses for Life
The names and numbers may vary but the situation is all too common. Approaching retirement at age 65, John and Jill Smith realized their monthly income from Social Security and pensions total $700 less than their fixed expenses. They have savings to fill the gap, but worry that their nest egg may not be sufficient to cover both their fixed expenses and their annual travel plans — especially if they are fortunate enough to enjoy a long retirement.
Prudent investors often tackle this problem by becoming ultra conservative with their money. They commit to withdrawing so little from their savings that they have almost no chance of using it all up — say 4 percent of their account balance per year — or they simply forego travel and most other forms of discretionary spending.
There is an alternative approach, one that could be considered even more fiscally conservative and yet simultaneously more freeing. It involves using some portion of your savings to purchase an annuity, which is a special type of insurance contract that can be used to generate a guaranteed stream of income for life. The idea is to use these payouts to cover your monthly income gap, which then frees you to use the balance of your savings as you like — without worrying that you’ll be unable to afford food and shelter down the road.
Thanks to recent product innovations, it is now easier than ever to tailor such a strategy to your personal financial circumstances. Annuity issuers have created optional features for their products that can hedge their long-term value against financial market declines; boost their value if the financial markets perform well; provide guaranteed payouts for your beneficiaries should you die before taking advantage of them yourself; and even provide extra income if you ever require long-term care.
“In an ideal world, your essential expenses in retirement should always be covered by guaranteed sources of lifetime income,” says Jeff Cimini, president of Fidelity Investments Life Insurance Co. “If Social Security and pensions are insufficient, annuities are a viable option for generating that income.”
The first step in executing this “lock it in” retirement income strategy is to identify your existing sources of guaranteed retirement income: Social Security benefits, pensions, and any other investment income you are confident of receiving, such as rent or royalty payments. From that, subtract your nondiscretionary living expenses. In addition to food and utilities, such items might include mortgage or rent payments, insurance premiums, vehicle expenses and property taxes. Your financial advisor can help you cover all the bases. If your expenses exceed your income, it’s time to consider an annuity.
There are two basic variations, fixed and variable. With a fixed annuity, you give a sum of money — the “premium”— to an insurance company, and in exchange the insurer promises to make regular payments of a specified dollar amount to you for a specified period of time—say, 10 or 20 years. Or, if you prefer, you can designate that period of time to be your lifetime, or the lifetime of another person, such as your spouse. This person is called the annuitant. The insurance company decides how to invest your premium, then pays your benefits as long as you or your designated annuitant are alive — even if your account value falls to zero.
With a variable annuity, you again pay a premium, or perhaps a series of premiums, to the insurance company. However, the dollar value of the payments you receive in exchange is not fixed. Instead, it is determined by the performance of the underlying investments you choose, typically a mix of stock and bond funds. As such, your payout can vary. However, to ensure against catastrophe and provide more certainty for buyers, most variable annuities today are sold with so-called “living benefits”— riders that guarantee some minimum level of payout regardless of how your investments perform.
Deciding which type of annuity to buy depends in part on how close you are to retirement. If you are at retirement age, you may want to use a “fixed immediate annuity” that begins paying out right away. These typically offer the highest guaranteed payout of any investment product, since the insurance company pools your mortality risk — your chances of dying — with that of its other fixed annuity customers. That simply means that if you die before you recover your entire investment, the insurer keeps the balance of your account.
“In the last 10 years, the insurance industry has seen a more than doubling in sales of immediate annuity products,” says Kevin McGarry, director of retirement income strategies for financial services firm Nationwide Financial, part of Nationwide Mutual Insurance Company. “People are gravitating toward these products to ensure that they have a guaranteed stream of income for life to cover essential expenses.”
Can’t abide the idea of losing your investment? You can buy an optional rider that will continue payments to your designated beneficiaries, although this will cost more money. Recently, for example, a 65-year-old Pennsylvania man who wanted to buy a fixed immediate annuity paying out $700 a month for life would have spent about $112,000 for it, according to the website ImmediateAnnuities.com. If he wanted payouts to continue to his beneficiaries for the first 20 years of the policy, assuming he died sooner, it would have cost him another $9,500.
If you’re not at retirement age yet, you could choose a “fixed deferred annuity” that lets you begin withdrawals at some specified date in the future: 5, 10, maybe 15 years out. Or you could choose a variable annuity, letting your account value grow until it’s time to begin withdrawals. In either case, a financial planner can help you forecast your expenses in retirement, and the minimum you can expect to earn from your annuity.
In some cases, a variable annuity may be a better choice than a fixed annuity even if you are already at retirement age. That’s because once regular payouts begin from a fixed annuity — once you’ve “annuitized” the contract — you can no longer make lump sum withdrawals from your underlying account. “A lot of Americans don’t have the luxury of having money that can be used solely to fill a gap in their monthly household income budget,” explains Jac Herschler, head of business strategy for Prudential Annuities, part of Prudential Insurance Company of America. “Their savings must do double duty: fill the gap in their monthly budget, but also be available for unforeseen major expenses.”
A variable annuity with a living benefit feature can fulfill that dual role, promising that you can withdraw a specified amount from your account balance each year for as long as you or your spouse live, no matter how your underlying investments perform during your retirement, and still access your remaining account balance in case of emergencies. You can do this because you don’t have to formally annuitize the contract to take advantage of the living benefit feature. “While your future guaranteed income amount may be reduced if you make a withdrawal exceeding your annual withdrawal amount, this type of flexibility is still important for most Americans, “ Herschler says. “It assures them that if they need money for a new roof or some other big expense, they have access to it.”
Finally, you may find a mix of fixed and variable annuities the optimal recipe for locking in retirement income. You could, for example, buy a “period certain” fixed immediate annuity to cover the gap between your monthly income and expenses for some fixed period of time — say 10 years. Meanwhile, you invest the balance in a variable annuity. During the first 10 years, the money in the variable annuity remains available for emergency expenses. Once 10 years is up, you can begin withdrawing money from the variable annuity, or cash it out and buy another fixed immediate annuity.
Daniel Herr, assistant vice president for product research and development in the retirement solutions group at The Lincoln National Life Insurance Co., says investors crafting a retirement income strategy sometimes forget about the potentially damaging impact that inflation can have on their plans. A simple way to address that with a fixed annuity, he notes, is to purchase an optional cost-of-living rider that will boost your annual payout in line with changes in the Consumer Price Index or some other common inflation measure. Investors in variable annuities enjoy some measure of inflation protection automatically, he adds, since their underlying investment portfolios have a chance to outperform inflation over time.
“Having a predictable stream of income is core to your retirement planning, but having the potential for your income to grow as a hedge against inflation is equally important,” Herr says.
In addition to accounting for inflation, it’s important for anyone considering annuities as part of their retirement income strategy to seek out counsel from a financial advisor who understands and appreciates their nuances. Terms, conditions and prices for annuities can vary greatly from one provider to another and from one type of product to another — just as one person’s financial circumstances can be quite different from another’s.
“There are many factors to consider — your marital status, your financial resources, the terms of any pension plans you may have and the way you structure your Social Security benefits, just to name a few,” Fidelity’s Cimini notes. “We feel strongly that people should talk to a financial advisor and do a full financial plan before considering the purchase of an annuity to cover their living expenses. If an annuity is the appropriate solution, this will help them choose the right one for their own circumstances.”