Annuities, offered by insurance companies, are a form of income insurance. Might you need an annuity, and if so, what type would work best? This article examines these matters, and recommends ways to find and evaluate firms that sell annuities.
Should You Consider an Annuity?
An annuity may seem attractive because it gives you guaranteed payments for the rest of your life. But it likely comes with fees and restrictions that may be hard to decipher. Furthermore, the net benefit to you may be less than you think, and more expensive than other options. Still, for some, certain annuities make sense.
Annuities are offered by insurance companies, and are best viewed as a form of income insurance.
You might hear them explained in other terms. Often, they are described as a method of risk-transfer. Your risk of outliving your investments is transferred to the insurance company. If you live far longer than expected, the insurer continues to pay you, anyway. They can do so because they have a large pool of annuitants. Some individuals in the pool live longer lives than expected; others, shorter. The ones with shorter lifetimes get paid only a portion of what they pay for their annuities. The insurance company keeps some of the left-over amount as profit and to cover administrative costs. It uses the rest to make payments to those whose lifetimes are unusually long.
As with any form of insurance, whether on your home, car, or health, there's always a chance you could receive benefits that exceed the amount you paid to the insurer. But that's not the norm. The norm is that most insured individuals will receive less in benefits than the premiums they pay.
So why do it? Because you may need protection against an uncertain future.Thus, at able2pay.com we strongly recommend that when considering an annuity, your first ask yourself a critical question: Do you need income insurance, knowing that it is likely to cost more in premiums than you will receive in benefits? Set aside, if you can, any fear that when buying an annuity you are somehow losing your money to an insurance company. Instead, picture yourself alive and financially solvent past age 100. What decisions today might be sensible ways to assure that future vision?
Annuities are offered by insurance companies, and are best viewed as a form of income insurance.
You might hear them explained in other terms. Often, they are described as a method of risk-transfer. Your risk of outliving your investments is transferred to the insurance company. If you live far longer than expected, the insurer continues to pay you, anyway. They can do so because they have a large pool of annuitants. Some individuals in the pool live longer lives than expected; others, shorter. The ones with shorter lifetimes get paid only a portion of what they pay for their annuities. The insurance company keeps some of the left-over amount as profit and to cover administrative costs. It uses the rest to make payments to those whose lifetimes are unusually long.
As with any form of insurance, whether on your home, car, or health, there's always a chance you could receive benefits that exceed the amount you paid to the insurer. But that's not the norm. The norm is that most insured individuals will receive less in benefits than the premiums they pay.
So why do it? Because you may need protection against an uncertain future.Thus, at able2pay.com we strongly recommend that when considering an annuity, your first ask yourself a critical question: Do you need income insurance, knowing that it is likely to cost more in premiums than you will receive in benefits? Set aside, if you can, any fear that when buying an annuity you are somehow losing your money to an insurance company. Instead, picture yourself alive and financially solvent past age 100. What decisions today might be sensible ways to assure that future vision?
Who Needs Income Insurance?
Getting to the heart of the matter, here are some factors to consider, when deciding whether income insurance makes sense for you:
If, after careful analysis, you've decided that you need income insurance, what type of annuity should you consider? And from what insurance companies? Read on for some answers.
- Are you close to retirement or already retired? If so, read on. If not, wait until retirement is closer, when your savings, sources of retirement income, and possible need for income insurance will be clearer. Don't consider annuity products when your needs for income insurance are inscrutable.
- What core, non-discretionary expenses must be covered from sources other than work-related income? For retirees, the true essentials are most likely the threesome of (a) food; (b) housing, including rent, home-owners insurance, utilities, occasional repairs, mortgage payments, association fees, and property taxes, as applicable; and (c) medical expenses, such as co-payments and Medicare Part B premiums. Don't include entertainment, vacations, and other expenses on which, in hard times, you could cut back.
- How much will you receive from Social Security? It has cost-of-living adjustments and is by far the best form of income-insurance available to most Americans. You are well-advised to maximize the amount you get by working for up to 35 years at jobs that withhold Social Security taxes and by postponing your Social Security retirement benefits to the latest date possible.
- Do you or will you have a pension? If so, how much will it pay when you stop receiving income from work?
- Add your Social Security and pension amounts, and compare them to your core, non-discretionary expenses. Is there a shortfall? If so, you might need income insurance. The answer depends on your other sources of retirement income, so read on.
- Find the total of your retirement savings, and calculate how much of it you can afford to spend in one year, without risking that you will outlive your savings. Our safe payout calculator will do this for you, with options adjustable to your personal circumstances. One of the methods available from the calculator is the Life+6 rule, which you can also compute yourself, like this. (a) Find your life expectancy (years remaining to live) from the Social Security website. (b) Add six years. (c) Divide your total retirement savings by that number. The result is what you can afford to spend this year. You must recompute the number each year, as your life-expectancy and savings will change. Note that this method assumes you will have some of your savings (minimum 20% to 30%) invested in stock funds.
- Calculate the total of your Social Security benefits, pension payments, and income from retirement savings. Is this total less than or about the same as your core, non-discretionary expenses? If so, then you need income insurance. On the other hand, if there's a surplus, you don't need it. How big a surplus is adequate? You will have to decide for yourself, after estimating your retirement budget. Here are some rough guidelines. According to research by economists who specialize in retirement, a typical retiree's expense budget will be about 75% of their pre-retirement spendable income. As a buffer, you might want to add 10% for discretionary spending. By this estimate, you don't need income insurance if your Social Security plus pension plus income from savings equals or exceeds 75% to 85% of your pre-retirement spending.
- Have you kept a reserve fund? If you are considering an annuity for income insurance, don't use all your savings. Keep a reasonable amount for a reserve fund, to cover unplanned expenses and emergency needs. To estimate how much you may need in a reserve fund, read this article or try our calculator for retiree reserves.
- Finally, here's the last step. It depends on why you want income insurance. Is it because, after setting aside a modest reserve fund, your remaining income is less than you need for core expenses? Then you may be wise to put all your savings (but not your reserves) in the right kind of annuity. Naturally, in this circumstance, you would also consider whether you can reduce your expenses or work part-time. Alternatively, do you want income insurance because, after setting aside a reserve fund, you have sufficient income but are worried about living very long or anxious about how to invest your savings? Then you might consider buying an annuity with some of your retirement savings, in order to stabilize and insure your income. One idea would be to annuitize about half your non-reserve savings, and invest the rest in stocks and bonds.
If, after careful analysis, you've decided that you need income insurance, what type of annuity should you consider? And from what insurance companies? Read on for some answers.
What Type of Annuity is Best?
If you search for annuity products, you will be swamped with choices and flooded with terminology. After draining out all the marketing and hoopla, you may find that for income insurance, one option is the undisputed winner: a single-premium, immediate income annuity (SPIA), with a lifetime guarantee and an annual increase. Let's unpack that:
- Single-premium: At one point in time, you pay a fixed amount of money for an insurance contract that guarantees income payments to you (and optionally to your spouse or partner). The alternative to a single-premium contract is one that you purchase over time, perhaps many years, sometimes called an "accumulation" annuity. Why is single-premium better? Because your payment to the insurance company is irrevocable. It's not like a mutual fund, where you can withdraw your deposits if you change your mind. Once you've paid the insurance company, the money is theirs. They will return payments to you only under the terms of the contract. Even if the contract allows some form of cash refund, there will be fees, restrictions, commissions, or penalties that keep you from getting back the full value you could have achieved by keeping your deposit and investing it safely. It's better to make a single payment at or near your retirement date, when your needs and objectives are clear.
- Immediate income: The contract specifies that your income payments will start right away (within 12 months at most). Sometimes, this option will be described as a "fixed" payment, or possibly "guaranteed." The words to avoid are "deferred" (the payments start in the future), "variable" (the payments may vary with the performance of a market, such as stocks, bonds, or real-estate), and "indexed" or "guaranteed income rider" (the payments are pegged to a complex, high-cost strategy that tries to smooth out a volatile market).
- Lifetime guarantee: Payments will come to you as long as you live, and optionally to your surviving spouse or partner therafter. The alternative would be an annuity that pays for a fixed period, such as 5 or 10 years. That's not income insurance for the rest of your life. Possibly, under some circumstances, a 5-year or 10-year fixed-period contract from an insurance company might be a good investment for other reasons. In that case, you should compare the insurance product to alternatives such as bank CD's and no-fee purchase of U.S. Treasuries from www.treasury.gov. For income insurance, however, get a lifetime guarantee.
- Annual increase. The annuity automatically increases its payout every year. Annuities that adjust for each year's actual rate of inflation, in the same manner as Social Security benefits, may be hard to find from top-rated companies. Much easier to find will be ones that increase from 1% to 5% annually. When selecting a rate of increase, here are some guidelines to consider. Since 1871, the U.S. inflation rate for consumer prices has been 2%. That's also the target-rate currently set by the Federal Reserve. In the last 100 years, the rate has been 3%, mainly because of spikes in inflation after the two world wars and the Nixon-era price controls. Health care has tended to rise faster than other consumer prices, but the pace has moderated recently. Finally, research suggests that most retirees spend less as they age. So if your life-expectancy is short, say, 10 years or less, you might reasonably opt for a small annual increase or none at all. All things considered, 3% may be sensible for anyone younger than 80, but you should make your own decision.
- Your spouse or partner, if you have one. Be sure that 100% of the annuity value will be paid to a surviving spouse or partner. Doing so will reduce the monthly payment, but it's necessary unless your spouse or partner is much wealthier than you (in which case, they should be buying the annuity and guaranteeing it for your joint lifetimes). Bear in mind that when one of you dies, the surviving individual will receive the larger of your two Social Security benefits. Because your total Social Security payments will decrease, it's important that your annuity payments not decrease. Don't fall for the sales pitch that you should buy life insurance to benefit your retired spouse or partner. Mathematically, as any economist will confirm, annuities and life insurance are opposites. One pays if you live; the other, if you die. It makes no sense to hold both at the same time. If you have a spouse or partner, it's most cost-effective to insure your joint incomes with term life-insurance while you are working and with Social Security and SPIA contracts when you both retire.
- Your estate, if you want to leave one. Should you intend to leave bequests to your children or charity, you must keep some of your assets in investments other than annuities, such as home equity or stocks and bonds. And don't fall for the sales pitch that you should buy so-called "permanent" or whole-life life insurance for a bequest. The fees for such insurance are virtually certain to be higher than those of sensible investments in low-cost index funds, and your options for spending your assets will be more flexible with the investments.
What Insurance Companies Are Best?
Before you start looking at annuity products, commit to getting competitive quotes. Don't go for the first pitch you find, even if it's from a well-respected, well-known firm, because the decision is normally irrevocable. Comparison-shopping is a must.
For starters, you can get quotes for SPIA contracts at IncomeSolutions.com. Two of the good investment firms we've reviewed also offer online-services to compare annuity products from different insurance companies. At Vanguard, if you have an account, you can log on to a service called Vanguard Annuity Access (which is actually a handoff to IncomeSolutions.com). At Fidelity, there's a public page (no account required), where you can get a preview of the Fidelity Insurance Network, a set of insurance companies partnering with Fidelity to sell annuities. To get a specific quote, however, you'll need an account. While we've previously given good marks to a third firm, TIAA, for certain retirement accounts, their annuity products don't match the criteria above. In particular, their traditional income annuities (called "TIAA Traditional") don't guarantee annual increases and are therefore vulnerable to inflation.
You'll need to do additional homework on any insurance company, before purchasing an annuity. In particular, you should know how its financial stability is rated. The very best insurance companies, roughly the top 30, will advertise at least two of the following:
The COMDEX ranking compiles data from all rating agencies for all insurers, but the rankings are not free to the general public. COMDEX ranks go from 100 down, with the top 40 companies getting ranks of 95 or better; the top 100 have ranks of 88 or higher.
Two companies that get the highest possible COMDEX rank of 100 and sell the kinds of annuities recommended here are Northwestern Mutual and New York Life. From their websites, you can find an insurance agent in your area who sells their products. For other good alternatives, you may be able to get COMDEX ranks by searching the web for a salesperson or insurance agency willing to provide them.
For starters, you can get quotes for SPIA contracts at IncomeSolutions.com. Two of the good investment firms we've reviewed also offer online-services to compare annuity products from different insurance companies. At Vanguard, if you have an account, you can log on to a service called Vanguard Annuity Access (which is actually a handoff to IncomeSolutions.com). At Fidelity, there's a public page (no account required), where you can get a preview of the Fidelity Insurance Network, a set of insurance companies partnering with Fidelity to sell annuities. To get a specific quote, however, you'll need an account. While we've previously given good marks to a third firm, TIAA, for certain retirement accounts, their annuity products don't match the criteria above. In particular, their traditional income annuities (called "TIAA Traditional") don't guarantee annual increases and are therefore vulnerable to inflation.
You'll need to do additional homework on any insurance company, before purchasing an annuity. In particular, you should know how its financial stability is rated. The very best insurance companies, roughly the top 30, will advertise at least two of the following:
- AM Best rates them A++ or A+.
- Standard & Poor's (S&P) rates them AAA, AA+ or AA.
- Moody's rates them Aaa or Aa1.
The COMDEX ranking compiles data from all rating agencies for all insurers, but the rankings are not free to the general public. COMDEX ranks go from 100 down, with the top 40 companies getting ranks of 95 or better; the top 100 have ranks of 88 or higher.
Two companies that get the highest possible COMDEX rank of 100 and sell the kinds of annuities recommended here are Northwestern Mutual and New York Life. From their websites, you can find an insurance agent in your area who sells their products. For other good alternatives, you may be able to get COMDEX ranks by searching the web for a salesperson or insurance agency willing to provide them.
Dubious Deals
The features, options, and terminology for annuity products are mind-numbing. They generally have limitations and drawbacks, compared to SPIAs. Here are some examples you may encounter:
- Deferred Income Annuities (DIA) are similar to a SPIA, but instead of starting your income payments immediately, you defer them to a future date. For example, you might pay for the annuity now, but collect no payments until, say, age 75 or 80. A recently introduced variant, with the awkward name Qualified Longevity Annuity Contract (QLAC), may be offered within a 401(k), 403(b), or 457 plan or a traditional IRA (but not a Roth IRA). Suppose you purchase a DIA or QLAC for $100,000, with payments to start 10 years from now, but you die before the first payment. A QLAC and possibly a DIA (depending on the contract terms) will return $100,000 to your beneficiearies. What about the interest earned on your $100,000, which may be substantial, or commissions to the salesperson? Be sure you know the answer. More likely than not, your assets would be greater if you invested the $100,000 safely and purchased a SPIA 10 years hence.
- Charitable Gift Annuities (CGA) are often structured as a SPIA to you, possibly with some tax benefits, plus a donation of residual principal to a charity. Because it's a SPIA, you may find a CGA more attractive than one where all the profits would go to an insurance company. All well and good, but keep two cautions in mind. First, the payments depend in part on the financial stability of the charity. Make sure it's large, well-financed, and governed by a strong Board of Directors. Second, other options for generating bequests may enable you to leave more to charities than a CGA would do. Examples might include systematic donations during your lifetime, and a balanced portfolio of long-term investments. Our safe payout calculator helps you do bequest planning, whether to charities or your heirs, if that's your goal.
- A variable annuity with a guaranteed income rider is tied to the performance of a mutual fund, typically with a mix of stocks and bonds, but with a supplemental guarantee that the amount of your payment is variable only in one direction. It can go up, but won't go down. There's a catch, of course. Suppose, right after you purchase the annuity, the underlying fund goes down for a few years, then takes a few more years to return to its original level. In that case, your payments would stay flat for many years, only going up after the market has fully recovered. In the meanwhile, inflation may be eroding the value of your payments. In short, the worst time to buy a guaranteed income rider is when markets are hot and optimism is high, which may be the very time when you are most tempted to do it. Furthermore, without a rider, a variable annuity can either increase or decrease in value, just like a mutual fund of stocks or bonds, but with higher underlying costs. If instead you purchase a SPIA with an annual increase, your payments will grow every year, no matter what inflation and the markets may do. (For a more detailed analysis, see this post from June 2015 on our able2pay.com News page.)
Disclaimer: Historical data cannot guarantee future results. Although a mixture of bonds, stocks, and other investments may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, firm, or type of insurance. You are responsible for your own investment decisions. Please read our full disclosures and Fiduciary Oath.
