Key Considerations About Including Annuities as Part of Your Retirement Plan

annuities and longevity insurance

Many of us have heard of annuities but few understand how they work and if they should be part of your retirement plan. I’ll explain.

Are you approaching retirement? Are you wondering how much of your savings you can safely spend? Would you like guaranteed income to supplement your Social Security benefit? Are you worried that you’ll run out of money before you run out of time?

If you answered yes to any of these questions, it may be sensible to convert some of your savings to an annuity when you are ready to retire. However, annuities are more complicated than they need be, have many variations, and may have have large and well-hidden fees. They’re not easy to sort out but here’s a guide.

What is an annuity?

Briefly, an annuity almost always only makes sense to purchase around retirement age as there are better options to invest your savings before that time. The only annuity to consider is the simplest and lowest cost — a single-premium immediate annuity (SPIA). Forget about complicated variable annuities or those attached to whole-life insurance plans — they’re for the salesperson’s benefit, not yours.

An SPIA is the opposite of term life insurance. With life insurance, you periodically pay a premium and in return, your beneficiary receives a lump-sum payment when you die. With an SPIA, you make an upfront lump-sum payment and in return, you receive monthly pay-outs until you die. Think of it as a pension plan that you purchase from an insurance company, rather than one you receive from an employer.

When an insurance company sells you life insurance, they hope you live forever; with annuities, the insurance company “hopes” for your quick death. Annuities are best thought of as longevity insurance. You “bet” that you will live a long life and if you do, you will receive more than you originally paid. The insurance company “bets” on you living a short life so its profit is maximized.

What else should you consider?

A QLAC — qualified lifetime annuity contract — is a special kind of SPIA that is designed to work inside of an IRA or 401K and offers two important features that make it the best way to buy an annuity for most people:

  1. For the purposes of calculating your required minimum distributions (RMD), your IRA balance is reduced by the amount of QLAC you purchase. This has the benefit of shifting your RMDs from your early years of retirement to later years. When you receive the annuity payments, they will be treated as a taxable distribution from your retirement account.
  2. You can choose to defer when you begin receiving the payments until as late as age 85. If you don’t need the money in your earlier years of retirement, this has the benefit of giving you a larger payout amount and thus increasing your longevity protection.

You can choose to have these payments be inflation-adjusted or have a survivor-benefit (i.e, continue to be paid to your spouse if you die first), but these features are more costly — either in the form of a higher up-front payment, or reduced monthly benefits.

One last consideration is that annuities are not guaranteed in a manner similar to how FDIC insurance protects bank deposits. If the insurance company were to go bankrupt, your future payments would be at risk. Yes, there are state guaranty pools that may provide some protection but you don’t want to test them and find out how solid they are. This is a structural defect with annuities and one reason why you should not annuitize all of your savings.

How are annuities priced?

Pricing for SPIAs is straightforward as you only need to focus on the payout ratio. This is the percentage of the amount you paid for the annuity that is repaid to you each year in monthly payments. This is not the same as the implied investment rate of return.

The payout ratio is based on your age, the current level of interest rates, and your gender. Men have a shorter life expectancy so receive a slightly higher payout ratio than women.

For example, the payout ratio for a 70-year old man purchasing an immediate annuity is currently ~7.4% (for a woman, it is 7.1%). This simply means that if you purchased an annuity for $100,000, you would receive annual payments of $7,400, or monthly payments of ~$617. These would last until your death.

You would need to live ~14 years to have been paid back the full amount of your annuity purchase (and longer, if you include the foregone interest). Annuities make good financial sense if your life expectancy is longer than average.

Who should consider an annuity purchase?

You should not buy an annuity if you:

  • are still working. Don’t buy them as an “investment” at an earlier stage of life or as part of a whole-life insurance plan. Retirement age is the time to consider this.
  • receive a significant pension from another source, perhaps in addition to Social Security. An annuity is probably redundant as you already have a guaranteed source of income.
  • believe you have a shorter than average life expectancy.

You should consider an annuity if you are entering retirement age and would like to:

  • have “longevity insurance” to ensure you don’t outlive your money.
  • receive guaranteed income beyond your Social Security benefit.
  • diversify your retirement assets beyond just your savings.
  • reduce your required IRA distributions in the early years of your retirement.

Don’t think of an annuity as an investment as it won’t make financial sense; it’s insurance, similar to auto or life insurance. In this case, you’re insuring against a long life.

Do you have questions about whether an annuity makes sense for you? Get in touch to find out about my Retirement-Readiness service.

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