How income annuities can help in uncertain times

By: Kimberly Lankford

With today’s stock market volatility and financial uncertainty, an investment that offers guarantees can seem attractive. Income annuities can provide guaranteed payouts for life — no matter what happens in the stock market or how long you live. They can be particularly helpful for retirees who don’t have a pension and want to know that they have a regular check coming every month to supplement their Social Security benefits and cover their essential expenses.

But buying an income annuity is a long-term decision — you can’t get the money back in a lump sum after you make your investment. It’s important to understand how income annuities work and how they can fit within your financial plan so you can benefit from the stability but also make sure you have enough money available to meet your other needs.

How income annuities work. With the basic income annuity — an immediate annuity — you invest a lump sum and the insurance company guarantees that you’ll receive a fixed amount of money every month for the rest of your life.

If a 65-year-old man invests $100,000 in an immediate annuity now, he’ll receive about $484 per month for life ($5,800 per year). A 65-year-old woman would receive $458 per month ($5,496 per year). Payouts are lower for women because their life expectancy is longer.

You’ll get the largest monthly payouts with a life-only annuity, which continues to pay out for your lifetime, no matter how long you live. But the payouts stop when you die — whether it’s in one year or 30 years. The pooling of risk — the fact that some people will die early and some will live longer — is one reason why the payouts can be much higher than they are for other guaranteed investments.

If getting the largest monthly income is your biggest concern, then you may want to get a life-only annuity even though the payouts will stop when you die. If you’d like to make sure that the payouts will continue for as long as you or your spouse lives, you can get a joint-life annuity in return for lower monthly payouts. For example, if a 65-year-old couple invests $100,000 in a joint-life annuity, they’ll receive $406 per month as long as either one of them lives ($4,872 per year).

You can also get an annuity that promises to pay out for a certain number of years, even if you die before then. A “life and 10-year certain annuity,” for example, will pay out for as long as you live or will pay you or your heirs for at least 10 years if you die before then. The longer the guaranteed period, the lower the monthly payouts.

How income annuities can fit within your financial plan. With today’s low interest rate environment, it’s difficult to find another investment that promises to pay more than 5% per year for your lifetime. But there’s a big difference from other fixed-income investments: You can’t access your principal again after you invest in an immediate annuity. As a result, you’d only want to invest a portion of your portfolio in an annuity and keep the rest of your money accessible for emergencies and other expenses or to leave to your heirs.

Also keep in mind that the fixed payout will lose purchasing power through time. Some companies let you buy annuities that adjust the payouts through time for inflation, but few people select those versions because the payouts start out so much lower. Instead, you can invest the rest of your money for the long-term to help supplement the immediate annuity and keep up with inflation.

A good way to figure out how much you may want to invest in an immediate annuity is to add up your regular expenses in retirement, subtract any guaranteed sources of income you already have (such as Social Security or a pension) and consider buying an immediate annuity to fill in all or part of the gap. If you have a pension, you may not need an immediate annuity if you already have enough lifetime income to cover your regular expenses.

If you have $2,500 in monthly expenses and you receive $1,500 per month in Social Security benefits, for example, you may want to invest enough money in an immediate annuity to provide $1,000 in monthly income. A 65-year-old man would need to invest about $206,000 in an immediate annuity to provide $1,000 in monthly income. (A 65-year-old woman would need to invest about $218,000.)

Knowing you have your expenses covered with guaranteed income for the rest of your life may make you feel more comfortable investing the rest of your money more aggressively — which could help the rest of your portfolio grow for the future and provide more money to cover other expenses, keep up with inflation, and leave an inheritance for your heirs or a charity.

Or you may decide that you don’t want to tie up that much money in an immediate annuity now, especially since interest rates are so low. Another option is to ladder annuities. You could invest enough to cover a portion of your expenses now, and then invest more money in an annuity in a few years, which can also help you cover rising costs from inflation. The annual payouts will be higher at that point because you’re older. For example, a 65-year-old man who invests $50,000 in an immediate annuity now could receive $242 per month, and a 70-year-old who invests $50,000 could receive $282.50 per month. And the payouts could be even higher by the time you are 70 years old if interest rates rise by then.

Longevity insurance. The biggest risk that an income annuity protects you against is longevity risk — the possibility that you’ll outlive your savings. Without a source of guaranteed income, you could run out of money in your 80s or 90s if you underestimate your life expectancy when calculating how much you can afford to withdraw from your savings in retirement. But longevity risk isn’t as much of a concern in the early years of retirement, so you might not need that guaranteed income until later. In that case, you may want to consider a deferred-income annuity (also called “longevity insurance”), which doesn’t start to pay out until your 70s or 80s but can provide much higher monthly income at that point.

For example, if a 65-year-old man invests $100,000 in a deferred-income annuity that starts to pay out at age 80, he could receive $1,596 per month ($19,152 per year) for the rest of his life. A 65-year-old woman would receive $1,410 per month ($16,920 per year) starting at age 80. Part of the reason why the payouts are so high is because of the pooling of risk — these payouts stop when you die, and if you don’t live to the starting payout date (age 80 in this example) you’ll receive nothing. It’s a way to convert your savings into the highest guaranteed income while you’re alive, if you’re most concerned about maximizing lifetime income. But if you want to make sure you or your heirs receive at least as much as you invested, you can get a return-of-premium version in return for lower monthly payouts ($1,229 per month for a man, or $1,137 for a woman).

Knowing that you’ll receive guaranteed income starting in your 70s or 80s can also be perfect timing to cover potential long-term care costs, which generally happen in your 80s. Also, you’ll know how long you’ll need the rest of your portfolio to last — up until the age the deferred-income annuity starts to pay out — which is otherwise impossible to predict because you don’t know how long you’ll live.

Tax benefits from QLACs. A Qualified Longevity Annuity Contract (QLAC) is a special kind of deferred-income annuity that offers an extra tax benefit: You can invest up to $130,000 from your traditional IRA into a QLAC (or up to 25% of the balance in your traditional IRA accounts), which removes that money from your required minimum distribution calculation and delays the tax bill on that portion of your savings.

You won’t have to pay taxes on the money in the QLAC until you receive it as income, which could start in your 70s or early 80s. If you kept the money in the IRA, on the other hand, you’d have to start taking required withdrawals every year starting at age 72 (and pay taxes on the withdrawals). You’ll still have to take RMDs on the rest of the money in your traditional IRAs, but the money you invest in the QLAC isn’t included in the RMD calculation. As a result, you’ll have to take smaller RMDs at age 72 and have a smaller tax bill on the withdrawals. For more on QLACs, take a look at How a QLAC annuity can help defer your taxes in retirement.

Have more annuity questions?

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