Protect against risk of outliving nest egg
Few of us would go without auto, home, life or health insurance. But the kind of insurance that protects against the risk of running out of money in old age is still greatly underutilized. It’s called a deferred income annuity or a longevity annuity.
I believe most people planning for retirement should strongly consider an income annuity, and a Brookings Institution report confirms that belief.
The concept of this type of annuity is simple. The buyer deposits a lump sum or series of payments with an insurer. In return, the insurer guarantees to pay you a stream of income in the future. That’s why it’s known as a deferred income annuity.
Guaranteed lifetime income is a cost-effective way to insure against running out of money during very old age. You get to choose when your payments will begin. Most people choose lifetime payments starting at age 80 or older.
The main disadvantage is that the annuity has no liquidity. You’ve transferred your money to an insurance company in exchange for a guarantee of future income. People who can’t afford to tie up any of their money shouldn’t buy a deferred income annuity.
Why are people reluctant?
Given that traditional company pensions have largely gone away, there should be great demand for income annuities, Martin Neil Baily of Brookings and Benjamin Harris of the Kellogg School of Management write in the 2019 Brookings Institution report, titled “Can Annuities Become a Bigger Contributor to Retirement Security?” But the demand just isn’t there.
Why? A few reasons: People overestimate their ability to invest money wisely.
They’re also concerned that if they don’t live long enough, the annuity won’t be worth the cost. But that’s a wrong-headed view, according to Baily and Harris, because it’s the insurance that’s the most valuable aspect of the annuity.
And the topic is confusing to consumers, in part because of the terminology. As Baily and Harris point out, annuities include both income annuities as well as fixed, indexed and variable annuities, which are primarily savings or investment vehicles.
How do income annuities work?
Income deferral is a key part of the equation. The insurer invests your money so it grows until you begin receiving income.
For instance, if you buy an annuity at age 55 and don’t start income payments until 85, you reap the advantage of 30 years of compounded growth without current taxes.
You could reap the same growth and tax advantages with a 401(k) or an IRA, but with a nonqualified annuity (one that’s not in a retirement plan) you don’t have to take required minimum distributions (RMDs) starting at age 72, and thus can extend tax deferral.
Furthermore, nonqualified annuities aren’t subject to annual limits on contributions like IRAs and 401(k)s are, so you can stash away much more if you like.
The longer you delay taking payments from deferred income annuities and the older you are when you start taking them, the greater the monthly payout.
It’s true that buyers who do not live to an advanced old age subsidize those who do, but such risk-sharing is how all insurance works — whether it’s home, auto or longevity insurance.
No worries about destitution
A deferred income annuity provides unique flexibility in planning your retirement. Suppose you plan to retire at 65. You can use part of your savings to buy a deferred income annuity that will provide lifetime income starting at 85, for example.
Then, with the balance of your retirement money, you only need to create an income plan that gets you from age 65 to 85 — instead of indefinitely. You don’t have to deal with the uncertainty of trying to make your money last for your entire lifetime.
The Brookings report makes a similar point. An income annuity can substitute for bonds in a portfolio.
For instance, suppose a couple’s allocation is 60% equities and 40% bonds. The couple could safely sell all their bonds and use the proceeds to buy an income annuity. Holding an annuity provides stability in a retirement portfolio, making it unnecessary to hold bonds, or to hold the same amount in bonds.
Another benefit: since you know you’ll have assured lifetime income later on, you can feel less constrained about spending money in the early years of your retirement.
Annuity options to consider
If you’re married, you and your spouse can each buy individual longevity annuities. Or you can purchase a joint payout version, where payments are guaranteed as long as either spouse is living.
What happens if you die before you start receiving payments, or after only a few years, when the total amount of payments received is less than the original deposit?
To deal with that risk, most insurers offer a return-of-premium option that guarantees your beneficiaries will receive the original deposit premium.
This is a popular option, but it does reduce the payout amount slightly when compared to the payout amount without the return-of-premium guarantee. If you don’t have a spouse or anyone else you want to leave money to, you won’t need this option.
The Brookings report “Can Annuities Become a Bigger Contributor to Retirement Security?” can be downloaded at bit.ly/incomeannuity.
© 2021 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.